WHAT ARE CENTRAL BACKED DIGITAL CURRENCIES (CBDC)?

Cryptocurrency has always been in news since its launch, either due to price volatility, ban, or upliftment of the ban. There are multiple notions attached to the use of cryptocurrency – will it replace fiat currencies and reduce the demand of central banks’ money, is it potent enough to become an alternative means of payment, is it as trustworthy as the fiat money and so on.

Cryptocurrency attracts much attention because it has challenged the paradigm of state-supported currencies and the dominant role of central banks in the traditional financial system. The swift expansion of the crypto market is giving rise to a lot of central banks to struggle with their monetary regulation system.

The central banks interfere in the matter of cryptocurrency either by regulating or banning them or by issuing CBDCs basis the respective jurisdiction. CBDCs are Central Bank Digital Currencies which can either be a digital form of fiat currency or by issuing state-issued cryptocurrency.

With the recent lifting of the ban on cryptocurrency trade in India and South Korea following the league, there is a clear indication that countries are moving towards the adoption of cryptos. This move is in anticipation of a host of benefits like providing stimulus to financial innovations, opening up of financial options to places with no access to financial services, non-inflationary in nature, the possibility of additional income for Government by making legal cryptos taxable, lower transaction costs, maintenance of privacy due to decentralization, elimination of frauds, quick-permanent and hard to fake transactions. Despite a long list of pros, there is a possibility of fraud or theft, high mining costs invested in mining, volatile markets, and limited vendor acceptability of Bitcoins.

CBDCs	P2P Cryptocurrencies
Centralized system of control	Decentralized system of control
Technology-neutral	Blockchain/DLT-based
KYC-enforced	Pseudonymous (anonymous in extreme cases)
Concentrated control and interference	Resistant to censorship and interference
Monetary policy: adjustable, centrally-driven and opaque	Monetary policy: Pre-defined, algorithmically-driven and transparent
Credit-asset; Intended as a legal tender	Commodity-asset; Not recognized as legal tender

 

Then there are countries like Luxembourg, Belarus, Spain, and the Cayman Islands which did not consider blockchain technology and cryptocurrency as a threat. They focused more on the disruptive potential of blockchain rather than the legality of currency. They believe that this decentralized monetary system can act as a means to attract investments in the technology companies that have been excelling in this sector, thus becoming a hub for fintech and fin innovation companies. There’s the upside of giving people a secure and cheap way to buy a thing. There are also serious privacy concerns. What is more, they do not enjoy the same degree of trust that citizens have in fiat currencies: they have been afflicted by notorious cases of fraud, security breaches, and operational failures and have been associated with illicit activities.

On the contrary, countries like the Marshall Islands, Venezuela, and many others are seeking to go even further and develop their own system of cryptocurrencies. Russia, in particular, is interested in some sort of digital currency to get around international sanctions and possibly even allow the government to tax its sizable black markets.

The Marshall Islands was the first country to make cryptocurrency a legal tender. It is used as a mainstream currency along with the USD which is the official fiat currency of the island nation. Called Sovereign (SOV), the currency is the world’s first national digital currency, introduced as a local currency to reduce the dependency on USD. CBDCs will help in improving the process of foreign exchange as they enable quicker and easier cross border transactions, revenue savings on printed money, financial access to unbanked individuals, prevention of money laundering and crime funding by tracking centralized cryptos. The SOV supply will be algorithmically fixed to grow at 4% each year to prevent runaway inflation.

Like every coin has a flip side this one too has – possible reduction of deposits in commercial banks, the core principle of decentralized crypto will be sacrificed as centralized governments maintain the blockchain.

In either of the ways Crypto has some advantages and some disadvantages, but where are we headed? Many regulators around the world have warned against trading in Bitcoin whereas some countries have already legalized it. Since the uncertainty prevails, economists, central bankers, finance ministers from around the world have been either encouraging or warning the investors.

 

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About the Author:
Ambika Sachdeva is an MBA student from IIM Lucknow. A commerce graduate who has worked in the financial sector and any new developments in the area triggers a curiosity in her.  She is passionate about expressing her thoughts via various mediums.