December 11, 2022

Central Bank Digital Currency (CBDC)

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On the 24th of November, 2022, a protest arose in the Netherlands where a group of citizens stood against the launch of a Central Bank Digital Currency (CBDC). While this digital currency functions similarly in the same way as stablecoins, both are built in very different ways in terms of design and control.

CBDCs, as the name suggests, are controlled by the central bank - the very same entity that issues legally tendered fiat. CBDCs are essentially the digital version of cash, which are backed by existing banknotes - making it virtually risk-free. With this design, CBDCs pose a great alternative to traditional fiat currency. Notwithstanding the volatility of its value against foreign currencies, volatility is not an issue for CBDCs. Depegging disasters are also not something to be concerned with. The government could also easily automate monetary policies that are especially useful in times of emergent crises. For example, it is possible to increase or reduce the supply of CBDCs digitally.

These features don’t seem to be too bad, don’t they? So, why the fuss against CBDCs?

Pseudonymity vs. Privacy

Many argue that CBDCs, though commonly seen as an innovative move by governments, are just a subpar version of stablecoins - cryptocurrencies built on the blockchain. CBDCs are to be built upon a distributed database that works similarly to a blockchain, but there is a catch. Unlike the blockchain, the transactions will not be publicly viewable due to security reasons. Understandably, privacy may be kept safe, but it also means that a single entity has all of the data about the transactions of the public. A single point of failure is exposed.

With stablecoins, although all transactions are publicly viewable on the blockchain, all users are pseudonymously shown - only exposing the elements of a transaction that are crucial in proving the integrity of the system.  

Centralization: ‘CBDC, a digital jail’

The International Monetary Fund supports the launch of CBDCs and dissuades the use of stablecoins as they acclaimed, “where they are not regulated, stablecoins can circumvent controls on free capital movement while complicating macroeconomic management by the central bank.” Unlike decentralized stablecoins, CBDCs are totally controlled by the central bank - opening again the risk for a single point of failure. Centralized stablecoins are also controlled by a single entity that holds the reserves backing the stablecoin; a crucial distinction against CBDCs, however, is that every mint, burn, and exchange of a stablecoin is publicly viewable on the blockchain - immutable and verifiable.

Although the central bank can easily alter the supply of CBDCs in response to monetary policies, it can also easily do other undesirable acts. They may have the control over freezing CBDC holdings, flagging or blocking transactions, setting transaction limits, or even location & time limits.

This threat gets larger with the fact that CBDCs are not non-custodial unlike cryptocurrencies. All CBDCs are held by the central bank and may be controlled unfavorably against the public. Social credit score may even come into play. With this, CBDCs are very comparable to crypto stored in custodial or exchange wallets, which recent events have shown to be very concerning.

CBDCs allow the central bank to exude their control digitally, making it faster and more absolute. Whether the future looks dystopian greatly depends on the design and the control placed over CBDCs, should they ever be launched and adopted as the norm.