Do we need blockchain-based CBDCs?

The past four years have brought multiple changes in the blockchain ecosystem landscape, bringing a dose of volatility, as happens when any previously bleeding edge technology enters the mainstream. This extends to the actors who inhabit this space, varying from the brilliant to the shadier. It can also be said that multiple developments have impacted the development of technology in the mainstream.

Legislative efforts, such as the attempts to legislate taxation and other regulations, have started appearing. The technology integration into everyday use cases has been slow, with mass adoption still being a work in progress. But, given all this, blockchain is more relevant than ever, and one key example of this is a stablecoin.

Numerous countries, companies, and consortiums are looking into digitizing currency using DLT. Now states, namely central banks, are interested in banking (got it?) on the possibility of instant settlement and instant transfers between actors in this global heterogeneous banking environment.

This article will look at what a stablecoin is, what Central Bank Digital Currencies (CBDCs) stand for, and what blockchain can and can’t do as a potential solution.

What are stablecoins?

A stablecoin is a type of cryptocurrency that maintains price stability — reserve assets back Stablecoins, representing financial assets denominated in foreign currencies and held by central banks. The most predominant reserve asset considered is the US dollar. Reserve assets are used to balance payments and have four primary characteristics: they must be physical assets, readily available to monetary authorities, easily transferable, and controlled by policymakers.

Stablecoins have gained traction for having the advantages of both payments of cryptocurrencies and fiat currencies. The transaction is processed instantly and benefits from cryptocurrencies’ security and privacy, also being volatility-free stable valuations of fiat currencies.

Based on their working mechanism, there are three categories of stablecoins:

• Fiat-Collateralized Stablecoins, such as the U.S. dollar, gold, silver, and oil, maintain a currency reserve as collateral to issue a suitable number of crypto coins.
• Other currencies back Crypto-Collateralized Stablecoins. Because the reserve cryptocurrency may be prone to high volatility, many cryptocurrency tokens act as reserves for issuing a lower number of stablecoins. An example of such a stablecoin would be MakerDAO’s DAI, backed by Ethereum.
• Non-Collateralized (algorithmic) Stablecoins, which include a working mechanism similar to that of a central bank, retain a stable price. Non-collateralized stablecoins do not necessarily use any reserve and can be implemented by a smart contract on a decentralized platform that can run autonomously.

What are CBDCs?

CBDC stands for Central Bank Digital Currency (also called digital fiat currency or digital base money) and represents the digital form of fiat money.

CBDCs are Bitcoin-inspired, but their nature differs from cryptocurrencies because they are established by law and can serve any banked individual. In contrast, legal persons accept virtual money as a means of payment, usually controlled by their developers and used by a specific virtual community. Central bank digital currencies have two main properties. Firstly, CBDCs are digital assets.

CBDCs are accounted for in a distributed or not distributed digital ledger. This is considered the only reliable source of currency. If a coin is not on a digital ledger, its similarity with fiat currency is almost 1:1, as it needs the central authority to confirm its validity. The same principle applies to transactions, including this type of coin.

On the other hand, distributed ledge currencies rely on the self-auditability and immutability of the ledger. Secondly, CBDCs are central bank controlled and backed. Just like physical banknotes, CBDCs are managed by the central bank in terms of supply. If a nation’s economy would be a car, then the central bank is most similar to the engine. Just like the engine pumps fuel throughout the vehicle to keep it moving, the central bank works to pump money into the economy to keep it growing. Sometimes economies need more money, and sometimes they need less.

How a bank regulates the amount of money circulating in the economic ecosystem impacts it both micro- and macro-economically. At a microeconomic level, a large supply of free and easy money leads to more individuals’ spending. Businesses find it easier to secure financing, and people can get personal loans and car loans more quickly. It affects the domestic product, the interest rates, the overall growth, and the unemployment rates at the macroeconomic level.

Why CBDC?

Multiple organizations and individuals adopt digital payment methods for the benefits they bring:

• Transactional efficiency. Time is money. A CBDC facilitates instant and intermediary-agnostic transfers, thus solving significant social and economic issues. For example, in Niger,? the mobile transfer implementation reduced the travel time to a cash-out point by 40 minutes compared to manual cash distribution. Apart from that, the waiting time for a typical manual cash transfer is about three hours. Based on average agricultural wages, the time savings attributable to the digital transfer channel for each payment translated into an amount large enough to feed a family of five for a day.
• Transparency and security. CBDCs are efficient solutions to problems people were unaware of when cash was the only payment option. They prevent illegal activities, such as money laundering, tax avoidance, tax evasion, and unreported employment, since the central bank tracks all the financial traffic. Accountability is harder to achieve with cash payments because they are anonymous and difficult to follow. According to Stanley Yong (IBM) , the interest in the development of CBDCs originated in 2008, when the financial crisis was triggered by “a lack of confidence in the delivery versus payment mechanisms that were available at that point in time.” To avoid that, CBDCs come against corrupt governments and illegal organizations, increasing accountability and lessening the risk of theft. For example, when the government made social security pension payments using digital smart cards instead of cash in India, there was a 47% reduction in bribe demands. The incidence of ghost recipients fell by 1.1 percentage points.
• Financial inclusion. Finally, every legal resident and citizen has the right to have a bank account and make digital transactions. Many social categories are disadvantaged and vulnerable to not having access to up-to-date financial services because they don’t know how to use them. These categories include the elderly, extreme poverty victims, refugees, and undocumented immigrants. There are currently 1.7 billion unbanked people worldwide, of which 1 billion own mobile phones. Therefore, enabling SMS-based hassle-free CBDC transfers (maybe M-Pesa inspired) will make digital systems truly financial-inclusive.

Competition between banks

Central banks that have been trialing CBDCs focused on low-cost and fast payments. CBDCs can be used for both retail and wholesale payments. While a retail CBDC means the digital version of traditional cash, a wholesale CBDC refers to a new, innovative, efficient infrastructure for interbank settlements. Retail CBDC would be adopted for payments between individuals, businesses, and others. Usually, there are more than 100,000,000 retail CBDC transactions per day. Wholesale CBDC would facilitate payments between banks and other entities with accounts at the central bank and other similar interbank settlement forms. The average number of CBDC transactions per day is less than 100,000.

To track money’s digital footprint, a bank needs a reliable and secure implementation for its CBDC. Therefore, a central bank digital currency would be implemented using the central bank’s database, the government, or trusted private-sector entities. The database would record every entity’s amount of money, abiding by the appropriate privacy policy.

The impact of CBDCs

The regulation around digital assets and distributed ledgers can be inconsistent and vary across different jurisdictions. Digital currencies would provide a real-time picture of the economic activity in a country or region and more accurate and timely financial data for the gross domestic product (GDP) estimates than those available today. As authorities try new approaches and react positively to new developments using CBDCs, the regulatory landscape may change rapidly favorably for society.

Organizations will need appropriate procedures and policies that will help them interact with digital assets.

Apart from policies, digital assets will also impact organizational resources. Senior management should consider having strategies that count the impact of the CBDCs on their organization and respond to the changing landscape. Digital asset teams will need the appropriate competence and capabilities to perform business operations and understand and effectively manage risk within the organization. Executives must decide whether or not digital assets are suited for their business.

The distributed ledger technology protocols may have different governance, technological, and organizational approaches, which necessitate redesigning the traditional frameworks.

There is a solution to these kinds of organizational issues, too. Instead of focusing on in-house development, businesses can consider working with a third party for digital assets services. But the level of complexity of a business model and the organization’s internal capabilities will dictate whether collaborating with third parties for digital assets-related uses could be an effective solution.

CBDCs could also negatively impact the commercial bank sector, particularly in times of economic stress, when citizens pull their savings from commercial banks and place them in risk-free accounts.

This risk may trigger a bank run and pressure the commercial banking sector. For this reason, many central banks are unlikely to implement retail CBDCs or may implement it using financial intermediaries.

Is blockchain necessary?

Blockchain technology would bring significant advantages to a CBDC regarding privacy and scalability. Firstly, the blockchain ecosystem provides innovative open-source technology such as non-custodial wallets, decentralized finance, and zero-knowledge cryptography. Moreover, the rules of a CBDC can be hard-coded in a protocol to facilitate compliance, such as third-party access to the system or wallet thresholds. Secondly, distributed systems ensure resilience, transparency around transaction history, and data availability. Besides, users do not need to be locked in by intermediaries to trust and use the CBDC.

A blockchain-based CBDC allows the central banks to control the currency and protect the independence and privacy of the CBDC’s use to the end-users. Ethereum might be the best-suited technology for a blockchain-based CBDC. The platform has proved its capacity to support networks with hundreds of users and more than 100,000 nodes. It is also the largest blockchain ecosystem, supported by more than 400,000 developers.

European Central Bank executives have reservations about using blockchain for CBDC implementations. It is unnecessary if a central party creates this digital asset. Still, they are open to the technology for wholesale CBDCs. It is limited to clearing institutions, commercial banks, and other entities with access to central bank reserves while also managing large volumes.

Closing

CBDCs and stablecoins are not interchangeable terms. While a central formal authority manages CBDCs, any private company can create stablecoins. It is vital to make this distinction. The necessity of blockchain for CBDCs is debatable, as explained above. If a central authority manages the currency, it becomes futile to use blockchain.

CBDCs are not necessarily the solution, given that most large transactions are digital and cross-border settlement is instant in most payment systems. At the same time, we still depend on bank holidays (but why?) and bank schedules to make inter-bank or cross-border transactions.

I think blockchain is unnecessary to implement instant settlements and faster transaction execution. We need automation to take place. Blockchain is required when no other traditional solution can be trusted.

We must keep in mind that the blockchain is not the universal answer to our technological grievances.