Cryptocurrencies have been a subject of much interest, being ridden with speculation, controversies, and unimaginable gains since their inception with the Bitcoin.
Alternatives to cryptocurrencies to minimize investment risks were introduced by way of stablecoins, which are cryptocurrencies that are backed by fiat currencies, commodities, other cryptocurrencies, or algorithms. Stablecoins serve as a bridge between the stable fiat currency and the volatile cryptocurrencies.
In parallel, governments to keep at par with the developments spurred by blockchain and a greater dependence on a digital infrastructure, came forward with CBDCs (Central Bank Digital Currencies), which represent an electronic record or a digital token of a country’s official currency.
Stablecoins can be of the following kinds, depending upon their backing entity, which in turn influences their market supply:
- Fiat-backed: It requires an issuer/ custodian e.g., Tether pegged to USD.
- Commodity-backed: It requires an issuer/ custodian e.g., Paxos Gold.
- Cryptocurrency-backed: Smart contracts are used to manage the issuance e.g., Dai pegged to ETH.
- Algorithmic: Smart contracts are used to manage the issuance e.g., NuBits.
CBDCs can be majorly of the following kinds, with possibilities of other designs depending upon requirements:
- Retail: The CBDC is directly provided by the central bank to the public with the central bank maintaining a record of the retail balances e.g., eNaira, e-CNY, Sand Dollar.
- Wholesale: The financial institutions work as intermediaries to provide retail payments to the public, whereas the central bank records wholesale balances e.g., wholesale CBDC by Banque de France.
Reasons for issuance of CBDCs
Some of the reasons are:
- Development and growing dependence on a digital infrastructure.
- Promotion of financial inclusion.
- Account creation barring the age barrier.
- Provide a cash equivalent, where anonymity is preserved and yet appropriate regulation exists to ensure that the CBDC is not used for money laundering or in the dark web, where cryptocurrency usage is prevalent on account of its pseudonymous nature and lack of KYC.
- The financial data would remain under the control of the government as opposed to a corporation or in public as through a public blockchain, where the data can be used for malpractices like tampering with voting during elections as happened through Facebook.
- Ability to give individuals the freedom to do away with cash, also witnessed through an increase in the usage of card payments and the progression towards a cashless society in Sweden and Finland, for example.
Retail vs Wholesale CBDCs
Retail CBDCs entail an enhanced responsibility on the central bank but might be a more lucrative option for small economies, whereas for larger geographies wholesale CBDCs that involve banks and financial institutions as intermediaries would be more pragmatic.
Banks perform many functions catering to the consumers like lending, investment, portfolio management, credit scoring and financial advice to name a few. These vary depending upon the local customs and the central bank cannot function to provide the same level of service without incurring massive upgrades in its own current level of functioning.
We can say divide and conquer is the best way forward, which in computer science, implies division of a task and delegation to different processing units, enhancing the speed of operation. If we consider a similar scenario, then digital currency without banks as intermediaries would provide a slow resolution to problems, whenever they come up. Consumers would lose access to the services provided by banks in the way they were used to, and the central bank would need to enhance the existing infrastructure to consolidate the market needs.
A single point of failure would exist with the central bank managing everything making it susceptible to hackers, who would want to have access to the data reducing both privacy and security. A digital currency introduction would come with its own novel challenges and minimum disruption in the existing infrastructure would guarantee a greater chance of success as opposed to bringing about a radical change, which works very well for startups and small corporations but might not work for large government institutions.
Advantages of CBDCs over stablecoins
Some of the advantages are as follows:
- CBDC would not require a blockchain for implementation.
- This implies less changes in the existing infrastructure and little to no user education.
- Privacy and security conforming to the existing mechanisms that are in place.
- Mass adoption of CBDCs would not pose a problem as major blockchains still grapple with throughput issues or when providing an adequate throughput, they struggle with storage issues.
- Stablecoins would be most likely pegged to a fiat currency or a cryptocurrency. When pegging to gold was done away with the dissolution of the Bretton Woods Agreement, what guarantee exists that a peg to a fiat or a cryptocurrency or an exchange-traded commodity would be stable enough for long term deployment? Thus, CBDC is the best way forward.
- Governments do not have to focus on the ethical nature of stablecoins to see whether they are Shariah-compliant or not. A digital version of the fiat currency would entail the requirement of no new endorsements by religious scholars.
- Consolidation of Arab countries to use a single currency as the eurozone, would become easier following an intermediated CBDC strategy without incurring the risk associated with the usage of a novel technology like blockchain through stablecoins. There can be multiple hierarchies in the issuance with the consortium of central banks of each country managing the supply and the wholesale records of the Arab region. The second layer can be of central banks in each country managing the wholesale records specific to that country, through the existing banks in the country. Banks and financial intermediaries would provide retail payments, as the central bank caters to the wholesale payments. This would be a three-tiered infrastructure. This three-tiered infrastructure would help maintain the autonomy of each country in the Arab region, while still enabling fast payments in the entire area using a CBDC, without the need for currency exchange.
Case for CBDCs
A CBDC is a much-needed step. People look for cheaper and faster options to conduct payment transactions and it does not matter to them who is the provider. A CBDC would fulfill this need and being regulated would imply adherence to AML/ CTF guidelines ensuring safety of all. The fact that financial accounts are in the control of the government would also imply prevention of money laundering and usage in the black markets, which is rampant with cryptocurrencies.
A CBDC can also help to facilitate micropayments, which would boost the economy, enable financial inclusion and the development of a new market dominated by novel revenue-generating mechanisms relying on using micropayments. If there is a demand in the market for digital currencies and the government doesn’t fulfill it, then other providers would come to the forefront to fulfill the need. This would expose the citizens to many scams that were seen through ICOs and even stablecoins. Thus, the foundation of a resilient digital economy, where the government can steer the country towards sound economic progress, lies in the establishment of a strong and secure CBDC.