Central Bank Digital Currencies: A Paradigm Shift in Monetary Systems
Written by Clint Rowe
In the ever-evolving world of finance, banks have historically held a pivotal role, serving as the bedrock upon which modern economies are built. For generations, they’ve facilitated transactions, safeguarded assets, and provided the financial infrastructure for both individuals and businesses; however, the digital age has ushered in a new era of transformation.
The advent of the internet redefined banking and reshaped economic landscapes by democratizing access to information and services. Now, we stand on the cusp of another seismic shift, one driven by blockchain technology, and in turn, Central Bank Digital Currencies (CBDCs). Much like the internet’s impact, blockchain and CBDCs have the potential to revolutionize financial systems. In this article, we explore the intersection of traditional banking and cutting-edge technology, delving into the opportunities and challenges posed by this dynamic fusion, which may redefine finance for generations to come.
Before we can understand what CBDCs and blockchain are, and how they will influence the global financial landscape, we must first understand fiat currencies. Fiat currencies, issued and regulated by central banks, play an indispensable role in any economy due to their multifaceted significance.
Firstly, they provide a stable and universally accepted medium of exchange, serving as the cornerstone of everyday economic transactions. Secondly, these currencies establish trust within an economy, their value backed by the credibility and stability of the issuing central bank and government, fostering confidence among consumers and businesses. Additionally, fiat currencies simplify domestic and international trade, acting as a common unit of account and standard of value, thereby facilitating efficient resource allocation and economic decision-making.
Furthermore, central banks employ fiat currencies as tools for implementing monetary policies, allowing for the regulation of inflation, economic stabilization, and support for overall economic growth. In essence, fiat currencies sustain economic activity, ensuring the seamless functioning of financial systems and monetary stability; however, these fiat currencies can be instrumental in a variety of payment methods. This is displayed below in the graphic, which displays the percentage of payments made with various payment methods by age cohort:
This depicts the shift away from physical cash as a means of financial exchange, as younger generations are leaning more towards these digitalized methods. Now although these fiat currencies are vital to an economy, the described utility of these currencies pose some challenges as well.
Primarily, issues of financial inclusion, transactional efficiency, and monetary stability are apparent. The solution to these barriers has been found in what is known as Central Bank Digital Currencies. Despite popular belief, CBDC’s are simply a digitalized fiat currency, meaning that aren’t just a replacement, but more so an alternative fiat that aims to solve the challenges described above. Unlike Bitcoin or other cryptocurrencies, CBDC’s are government backed legal tender, meaning they are interchangeable for the associated coins or banknotes within an economy. Blockchain technology, an innovation that utilizes a system of decentralized ledgers, is the tech that powers these centralized digital currencies.
Blockchain technology emerged with Satoshi Nakamoto’s Bitcoin, and decentralized ledgers have been increasingly implemented into new and innovative use-cases since then. The immutable, transparent, and trustless nature of this tech is now being recognized by central authorities around the globe, with countries such as France, Switzerland, Brazil, and the European Union now leveraging this innovation through central bank digital currencies. So how does this technology enable CBDC’s to function, and how do they solve the traditional issues that consumer face with fiat currencies?
Central Bank Digital Currencies operate off of blockchain’s system of decentralized, distributed ledgers. This ledger is a digital database that records all transactions and is maintained by a network of nodes (computers) spread across the network. These central authorities running the currency utilize a permissioned blockchain, which allows them to give access only to authorized participants to validate transactions and maintain the ledger. Unlike physical fiat currencies, CBDC’s are stored and exchanged through digital wallets which interact with the blockchain to send, receive, and manage the medium of exchange. This is essentially the basis of how CBDC’s function, but they offer much more.
One challenge reflected by physical fiat currencies is the lack of financial inclusion, which stems from the little access many individuals have to services facilitated by the traditional currency. This is depicted in a 2021 study by World Bank, which showed that 1.7 billion adults globally remained unbanked, and with no access to basic financial services. High transaction costs associated with traditional banking services, including fees for money transfers and account maintenance, render them unaffordable for many. This is displayed in the graphic below:
Geographical barriers also play a role, with rural and remote areas often lacking physical bank branches or ATMs. Moreover, millions of people lack proper identification documents, a requirement for accessing financial services. The Global Findex Database reveals that in 2017, women were 9% less likely than men to have a bank account in developing countries, highlighting gender disparities in financial access. Additionally, currency devaluation and inflation can erode the value of fiat currencies, disproportionately impacting those with limited access to investment options or savings accounts. These barriers, along with regulatory hurdles and limited credit access, contribute to financial exclusion for a significant portion of the global population.
One of the instigators in the exclusion of impoverished communities to financial services in the cost associated with them. For instance, international remittances often incur high fees, averaging around 6.8% and cumulatively reaching $689 billion in 2018. These remittances support unnecessarily high fees associated with basic financial functions; however, this is where CBDC’s aim to revolutionize the banking system. CBDC’s operate through the decentralized network of ledgers within a blockchain.
This allows related transactions to be executed directly in the chain, without the need for an intermediary like commercial banks or payment processors. This in turn allows that percentage fee associated with remittances to be forgone, making these financial functions cheaper, and thus more inclusive of less wealthy individuals. This is further substantiated by the lack of payment walls and minimum balance requirements, which CBDC’s don’t need to operate. The decrease in maintenance and self sufficiency of the blockchain makes these additional barriers to entry redundant, as the CBDCs don’t impose these challenges to fulfill the same functionality.
Additionally, the transparency and immutability of blockchain technology allows CBDC’s to link an identity to the accounts using the currency. This removes the barriers to financial services that the intense identification requirements bring. Those who may be missing formal government identification can thus be included, as their identity can be implemented within the on-chain identification applications. This is applicable to the estimated 1 billion people worldwide who possess no legal identity. With blockchain verification protocol’s, nearly anyone can participate in the financial services offered by a country. According to the world bank, 1.1 billion of the 1.7 billion unbanked adults have a mobile phone. This suggests that CBDC’s, which essentially only require internet access to use, will be immensely more inclusive to those who can’t access banking services.
As previously mentioned, many banking services that are facilitated with the physical fiat currency enact high inefficiency within transactions. CBDC’s operability on a decentralized ledger network means that all transactions will be recorded and cemented into this system. This enables all financial activity to be validated and visible to the administration overseeing the chain. When new transactions occur, complex cryptographic algorithms verify and add new transactions to a block through a chosen consensus mechanism, which can be tailored towards the CBDC specifically. This is a highly technical process; however, in brief, these central banks choose to between proof of authority, proof of stake, practical byzantine fault tolerance, delegated proof of stake, or hybrid mechanisms to run their blockchain. This process streamlines efficiency, as transactions can be enacted almost instantly through the consensus mechanism a CBDC operates with, but also ensures security. In fact, A World Economic Forum report states that blockchain and smart contracts can reduce fraud by 50% in financial operations.
Smart contracts essentially act as programmable algorithms that automate and streamline designated processes, as the blockchains algorithms can execute specific actions without the need of an individual operator. This automation can be applied to salary payments, loan disbursements, and supply chain settlements. According to Deloitte, the use of smart contracts in these areas can reduce operational costs by up to 40%. Smart contracts also allow conditional payments, meaning the chain can be programmed to release specified funds to suppliers upon the completion of a stated criteria. This saves time and resources, as McKinsey estimates that smart contracts could reduce administrative costs in supply chains by 20%.
This utility carries over into what is known as micropayments as well. CBDCs can use smart contracts to facilitate microtransactions, which are often impractical with traditional payment systems. This capability is essential for emerging use cases like the Internet of Things (IoT). According to Statista, the number of IoT-connected devices is projected to reach 75 billion by 2025, requiring efficient micropayment systems for future implications. This suggests that CBDC’s may be able to leverage this new technology for another avenue of future innovations as well.
Another innovation to banking efficiency these contracts provide is known as programmable finance. This reflects the core of smart contract capabilities, which is automation, as it promotes financial instruments and services to work autonomously. In this sense, CBDC’s can issue bonds, manage escrow services, or create decentralized lending platforms. This carries into the compliance and regulatory aspects of finance too, as CBDC smart contracts can embed compliance rules and regulatory requirements, automating compliance checks and reporting. This reduces the risk of regulatory violations, but also cuts costs for banking systems. The World Bank reports that regulatory technology (RegTech) solutions, including smart contracts, can help financial institutions save up to 20% in compliance costs.
This same technology enables instant and round-the-clock settlement of financial transactions, mitigating liquidity risks and reducing counterparty risk, as highlighted by the Bank for International Settlements (BIS). Furthermore, CBDCs utilize these smart contracts to streamline cross-border transactions, effectively cutting costs even more through eliminating delays associated with traditional correspondent banking. This can revolutionize global trade finance with a potential 50% reduction in operating costs. Additionally, smart contracts facilitate asset tokenization, from real estate to securities and commodities, thereby democratizing investment opportunities by enabling fractional ownership and tapping into markets previously considered illiquid, a transformation outlined by PwC to unlock trillions of dollars in value. Finally, CBDCs are well-positioned to engage in Decentralized Finance (DeFi) ecosystems through smart contracts, providing access to decentralized lending, borrowing, and trading platforms that have seen tremendous growth, with over $100 billion in total value locked in DeFi protocols in 2021.
Aside from providing financial inclusion and streamlining efficiency within the banking and financial services industries, CBDC’s also impact monetary stability. Every fiat currency faces the risk of value fluctuations, which can cause the weakening of an economy. This was recently displayed in 2017 Venezuela, as consumer prices were growing at 65,000% with the destruction of the nation’s fiat currency. At this time, one Venezuelan Bolivar was worth roughly $0.091 USD.
This issue can be directly targeted with the application of CBDCs as a fiat currency. CBDC’s, being completely digital and immutable, allows for banks to have great control over the money supply. Central banks can directly influence the quantity of CBDCs in circulation, making it easier to implement and adjust monetary policies to achieve price stability and economic growth. This makes controlling inflation, disinflation, and deflation much easier for these central authorities. Furthermore, CBDC transactions are recorded on a transparent and immutable blockchain ledger, providing central banks with real-time data on economic activity.
This data can enable more accurate and timely decision-making, allowing central banks to respond swiftly to economic fluctuations. This immutability also makes fraudulence and counterfeiting nearly impossible, contributing to a more stable and secure financial system. The digital nature of CBDC’s support crisis response and stimulus distribution during times of hardship for growing economies. This is another aspect of the blockchain-based currency that provides stability to the monetary system, as central banks can distribute CBDCs directly to individuals and businesses, providing rapid economic stimulus. This targeted and efficient approach can mitigate the impact of crises and promote economic stability.
Central Bank Digital Currencies (CBDCs) represent a transformative solution to the challenges that have historically plagued traditional fiat currencies. These challenges include financial exclusion due to high transaction costs, inefficiencies in the banking system, and vulnerabilities in monetary stability. CBDCs, underpinned by blockchain technology, address these issues comprehensively. They enable financial inclusion by eliminating identification barriers and offering efficient, cost-effective transactions that are particularly beneficial for marginalized populations.
Efficiency is bolstered through smart contracts, streamlining processes and reducing operational costs, while also facilitating micropayments crucial for emerging technologies like the Internet of Things (IoT). CBDCs revolutionize the financial sector by streamlining cross-border transactions, enabling asset tokenization, and participating in DeFi ecosystems, unlocking new opportunities for investors. Moreover, CBDCs enhance monetary stability by providing central banks with precise control over the money supply, real-time data for informed decision-making, and the security required to combat fraud and counterfeiting. In essence, CBDCs herald a new era in finance, promising inclusivity, efficiency, and stability for individuals, businesses, and economies around the world.
Sources
https://www.cgap.org/blog/measuring-financial-exclusion-how-many-people-are-unbanked
https://www.sciencedirect.com/science/article/pii/S106297692030020X
https://www.investopedia.com/terms/c/central-bank-digital-currency-cbdc.asp
https://www.imf.org/en/Publications/fandd/issues/2022/09/Picture-this-The-ascent-of-CBDCs
https://www.investopedia.com/articles/personal-finance/122915/worst-hyperinflations-history.asp
https://www.paymentsjournal.com/can-cbdc-also-implement-smart-contracts-maybe-e-krona-will/
https://cointelegraph.com/learn/what-are-cbdcs-a-beginners-guide-to-central-bank-digital-currencies
https://www.forbes.com/advisor/investing/central-bank-digital-currency-cbdc/
Disclaimer: The author of this article is not a licensed finance professional. This article is meant for educational purposes only. Crypto and investing are risky. Remember to do your own research.
