Can Central Bank Digital Currencies Replace Bitcoin?

Money, at the core of it, is a shared delusion. If you tried to pay for something with a piece of paper, you might get in trouble. Unless, of course, that piece of paper had a couple of markings that made it a $100 bill.

If we "share in the delusion" that cowries and seashells should be the money of the day, then they would be, right?

Well, not exactly.

To get money to statewide and worldwide acceptance, it has to be more than a shared delusion. Money has to be a shared delusion upheld by laws and mechanisms, like the government, enabling those laws. This is why some stores can choose to accept bitcoin as a form of payment while others don't. But no store within the UK, for example, can legally refuse the British Pound as a form of payment.

Fun fact: if you look at the ￡5 note, you'll see "I promise to pay the bearer on demand the sum of five pounds" written just under the words "Bank of England". Essentially saying that that piece of paper (now polymer) is only worth ￡5 because the Bank of England guarantees to pay the bearer that amount whenever they demand it.

Put in philosophical terms

Having shared delusion is a sufficient condition for a thing to be money

While having national systems upholding that thing is a necessary condition

With the advent and wide acceptance of cryptocurrency came 2 things that the government could not ignore:

People willing to transact in a currency that has no physical form/equivalent

Every unit of money that has ever been in your bank account has a physical equivalent somewhere in a bank. While you may not deal in any hard cash, all the bank transfers, card payments and online shopping you do is done with hard cash. This means countries still have to print notes and coins even when many people in developed economies rarely use cash. Cryptocurrencies have shown that people are more than willing to transact with currency that has no physical equivalent.

But didn't central banks already know this?

They kinda did.

Printing money that people rarely use in day to day transactions isn't exactly efficient, so why didn't they do this before now.

Technology to make it happen

It is not enough to be willing to do something, you also need to be able to do it.

When you send an email or PowerPoint, you send a copy of the original document you created. But when it comes to assets like money; it is important that when someone sends $100, for example, the person is not just sending a copy, but they are sending the original, so they don't send the same $100 to 100s of people when they only have 1 $100. This is the double-spend problem.

(Slight digression) Wouldn't it be fun to be able to spend the same $100 1000 times without needing to earn more? ??

This is why although emails and other online communication technology have existed for over 2 decades, there hasn't been any government equivalent to allow people to move money that lacks no physical form. After all, when you send an email, there's no paper equivalent anywhere to account for it.

Enter cryptography and blockchain technology

Cryptocurrencies came along with the technology that allowed people to transact with currency without the double-spend problem and need to have physical form to account for it accurately.

What is a Central Bank Digital Currency (CBDC)?

As the name implies, a CBDC is a currency that has no physical form (i.e. fully digital) issued by a Central Bank.

How would CBDCs work?

They would operate like the money we see on our bank accounts online, just without physical equivalents. The central bank would issue digital coins or notes, which would be held in a digital wallet and accessible on a smartphone.

Governments would also decide whether they want citizens to open accounts with the Central Banks or operate digital currency through existing commercial banks.

In Nigeria, the government went the existing commercial bank route. Many governments in Europe and Canada are considering the option of citizens opening bank accounts directly with the Central Bank. This may be because of the difficulty they had with disbursing stimulus cheques during last year's lockdown.

CBDCs would use blockchain technology to monitor supply and who owns what while users' data could be held by the Central Banks or an external party.

Among the world powers, China has the most developed CBDC called Digital Currency Electronic Payment (DCEP). It would work very similarly to the country's top payment processors, AliPay and WeChatPay.

The DCEP would work in 2 simple steps:

1. Users download the wallet app
2. They scan a QR code which the app generates (like the way we scan our debit/credit cards) when they pay for stuff at a terminal to complete transactions

In light of all of this, can CBDCs Replace Bitcoin?

Contrary to popular belief, I don't think CBDCs were created to compete with cryptocurrencies. And it shows in the design.

While countries can choose if they want their CBDC to be centralized or decentralized, I imagine most central banks will tend towards the centralized model; after all, they are called the CENTRAL bank, not the DEcentral bank ?? Of the 10 CBDCs that have been launched so far, none of them are decentralized. China's DCEP will not be decentralized either.

Governments aren't generally transparent entities. While they claim to share info, they often keep information from the public under the guise of "public interest". So it's unlikely that they would go the decentralized route.

Their unwillingness to go fully decentralized is where they lose the race against crypto.

But I don't think it matters that they lose that race. I don't even think that's the race they're in.

The tell lies in looking at China's DCEP.

China's DCEP is designed like a digital payment platform like AliPay, WeChatPay and their international equivalents, PayPal, Visa, Mastercard etc.

When viewed in that light, you realize that it wasn't designed to compete with crypto at all. If anything, they are competing with digital payment processors.

CBDCs are more a step towards a truly cashless society than a competitor with cryptocurrency

Cryptocurrencies were created as a response to distrust of people in institutions which include the government. It's nearly impossible for any government-issued thing to compete with crypto realistically.

What else can CBDCs do for Central Banks?

• It promises to make cross border payments faster and cheaper. Since no one needs to move any hard cash physically, settlement can be done in seconds.
• It could also reduce the costs Central Banks spend on printing money. Printing cash is a really expensive process. For example, it costs the US Federal Reserve 5.4 cents to print a one-dollar bill,?while printing a $100 bill costs 15.4 cents. Removing/reducing the physical component of cash used in daily living could potentially reduce costs.
• There's also the talk of financial inclusion. The age-old problem of "banking the unbanked". A frequent example cited to show how this would work is the M-Pesa in Kenya that makes transacting accessible to anyone in Kenya with a sim enabled phone. As I highlighted in my article on DeFi, it is unlikely that CBDCs in their current form can achieve this because, like other DeFi solutions, they require people to have smartphones to access them. In contrast, the M-Pesa can work on any sim enabled phone.
• Another more important reason is monetary policy.

Money is not just a means of exchange; it's also one of the primary control tools in any economy.

How so?

According to the IMF, the world economy, comprising 194 economies, in 2021 is worth?around $93.86 trillion?in nominal terms

The government can use money to stimulate an economy, limit growth, increase or reduce inflation etc. This is where monetary policy comes in.

The problem with many people moving to cryptocurrencies is that the government needs to control all (or most) of the money in circulation for monetary policy to actually work.

The?cryptocurrency market?is now?worth?more than $3 trillion - Al Jazeera, Nov 2021

While only about 3% of the world economy is in crypto, Governments can see the writing on the wall. They need to act to recapture the attention of their citizens to keep Central Bank issued currencies as an effective tool for monetary policy.

How can CBDCs be used in monetary policy?

A good case in point is China's DCEP. The DCEP is programmable. That means, in theory, it can be given an expiration date. If the economy is sluggish like it was during the global lockdown in 2020, the government can put an expiration date on the money and force people to spend.

Ideally, the government should not want to do this because if people feel the government can force them to spend money they wouldn't have spent otherwise, it would reduce people's willingness to use such currency.

What are the Risks of CBDCs

The typical risks with anything on the internet:

• Power outages shutting down an economy
• The threat of hacks

To mitigate this risk, most central banks say they'll issue CBDCs alongside regular banknotes and coins.

• There are also privacy concerns. Transacting online solely with CBDCs would mean that governments have access to all our spending data. How would they store that data? Who protects that data?

Next are the economic problems:

• In the past, people tend to withdraw all their money from banks to hold in cash in periods of economic uncertainty. Economists worry that in the era of CBDCs, in times of economic turmoil, people may pull their money from commercial banks to place it in CBDCs as this is a more convenient option than keeping all their money in cash. Which may exacerbate the financial crisis as commercial banks might collapse.

Then there are the problems facing any new generation currency:

• How do Central Banks prevent CBDCs from being used in money laundering, financing terrorism etc.?

Final Thoughts

There is no indication that CBDCs would be a more stable currency as Central Banks can still issue as much of it as they like. So the deflationary pressures facing the dollar could still affect CBDCs in the future. For now, it offers a clean slate to start from.

However, like Cryptocurrency, CBDCs are still young. Central Banks are still researching how to design their currency, so there is no need to judge them harshly now. In a decade or 2, the picture should be clearer.

Would you use a CBDC today?