Centrally controlled crypto: What is a CBDC?

The tension between central bankers and the crypto community is historically undeniable. 

When the Bitcoin (BTC) blockchain launched in 2009, founder Satoshi Nakamoto embedded the headline "The Times 03/Jan/2009 Chancellor on brink of second bailout for banks" as a sly critique of centralized financial institutions. Years later, central bankers, particularly in the European Union, continue to argue that Bitcoin and other cryptocurrencies are headed toward "irrelevance." Ironically, however, some countries have started developing blockchain-based digital currencies of their own: central bank digital currencies (CBDCs). 

CBDCs are government-backed digital assets built on blockchain technology, but they serve a starkly different purpose than decentralized cryptocurrencies. In this guide, we’ll explore what CBDCs are, how they compare to other cryptocurrencies, the motivations behind their development, and their potential benefits and challenges. We’ll also take a look at CBDCs currently in circulation across the globe.

What is a central bank digital currency (CBDC)?

CBDCs are hybrid digital tokens combining the legal status of government-issued fiat currencies with the peer-to-peer (P2P) infrastructure of cryptocurrencies. A country's central bank exclusively controls the issuance and circulation of CBDCs, just as they do with physical currency. However, instead of minting physical coins or printing money, central banks "mint" CBDCs on decentralized blockchains. While CBDCs function and hold the same value as traditional fiat, they exist solely in digital format.

CBDC versus cryptocurrency: Are they the same thing?

CBDCs and cryptocurrencies share a technological foundation, with decentralized networks of computers (nodes) verifying transactions and posting them on distributed ledgers. However, their objectives diverge significantly. Permissionless blockchains like Bitcoin and Ethereum (ETH) allow anyone who meets network requirements to participate in validation without a central authority. In contrast, CBDCs are tightly controlled by central banks and governments, which manage both issuance and inflation rates. These tokens typically operate on privately controlled "permissioned" blockchains, with restricted access to ledgers and pre-approved node operators.

Another major difference between CBDCs and cryptocurrencies is that CBDCs have a fixed value guaranteed by the issuing central authority. In contrast, most cryptocurrencies, with the exception of stablecoins, experience constant value fluctuations driven by real-time supply and demand.

Are CBDCs stablecoins?  

CBDCs function similarly to a class of cryptocurrencies known as "stablecoins," which maintain a steady value linked to a fiat currency. Stablecoins like USDT and USDC, issued by private companies like Tether Limited and Circle, rely on reserves or algorithmic mechanisms to stabilize their value. The primary distinction between CBDCs and stablecoins is their connection to government institutions.

While reserve-backed stablecoins rely on private entities to back their value with equivalent assets, CBDCs derive their stability from the authority of a country's central bank, positioning them as a distinct category.

Why do some countries want to issue CBDCs? 

Countries considering CBDCs often highlight their potential to increase efficiency within the national monetary system. As digital currencies, CBDCs integrate seamlessly with online government platforms, simplifying tasks such as tax payments and cross-border transactions. Their cryptographic protections enhance security while enabling governments to monitor and control illicit activities more effectively.

CBDCs also allow central banks to implement policy changes more quickly, such as adjusting the money supply or distributing stimulus via the blockchain. By integrating with banking apps, CBDCs offer citizens greater flexibility in managing their finances. Additionally, CBDCs could reduce the costs associated with minting and printing physical currency, along with the expenses tied to anti-counterfeiting measures for traditional bills and coins.

Pros and cons of CBDC currency

Blockchain purists oppose many aspects of CBDCs, arguing they may undermine key elements of the cryptocurrency revolution. While CBDCs offer potential benefits like financial inclusion and convenience, significant concerns remain.

Pros of CBDCs

• Payment efficiency: Leveraging cryptographically secured consensus mechanisms, CBDCs can streamline payment processing without sacrificing security. This efficiency could reduce processing times and fees for cross-border transactions, wire transfers, and clearing systems.
• Supplements existing financial services: Although CBDCs operate on decentralized blockchains, they can integrate with traditional payment rails, enhancing convenience and financial inclusion. Using these digital assets requires only a mobile device and a compatible wallet – no access to conventional banking services is necessary.
• Reduces criminal activity: The transparency of CBDC transactions makes them easier to trace than cash, helping regulators detect money laundering and tax evasion through immutable records.
• Potentially lowers net transaction costs: By cutting out intermediaries like banks and payment processors, CBDCs may reduce overhead costs, potentially lowering transaction fees for businesses and consumers.

Cons of CBDCs 

• Loss of privacy: Critics argue that CBDCs enable government surveillance, allowing authorities to track every transaction on immutable payment ledgers and access citizens' financial histories.
• Risk of currency freeze: Governments could freeze or restrict users' access to CBDCs at any time, raising concerns about unchecked power that could be used for purposes beyond criminal enforcement.
• Cybersecurity risks: Like other digital networks, CBDCs are vulnerable to hacking, bugs, and malware. Even with strong security, breaches could lead to major data leaks or financial crises.
• Implementation challenges: Transitioning to CBDCs involves significant logistical and regulatory hurdles, including infrastructure upgrades, IT standardization, and disruptions to the banking sector. 

What CBDCs are in circulation?

Around the world, dozens of countries are evaluating how CBDCs could fit into their economies, with nations like Russia, China, and Australia actively researching pilot programs. While many CBDC projects remain in testing, some governments have fully launched their own digital currencies:

• The Bahamas: In 2020, the Bahamas became the first country to introduce a blockchain-based national currency, the Sand Dollar. Backed by foreign reserves held at the Central Bank of The Bahamas, the Sand Dollar holds the same legal status as the Bahamian dollar (B$) for transactions across the island nation.
• Nigeria: In 2021, Nigeria made history as the first African nation to promote financial inclusion via its digital "eNaira" CBDC. The Central Bank of Nigeria (CBN) issues the eNaira and maintains the eNaira Speed Wallet app as the official CBDC wallet for transacting with this digital asset. 
• Jamaica: In 2022, Jamaica followed suit by introducing the Jamaican Digital Currency (JDC). The Bank of Jamaica issues the JDC, which can be used through digital wallets provided by banks or licensed payment service providers and maintains a 1:1 exchange rate with the Jamaican dollar.
• China: In 2014, the People’s Bank of China began exploring the development of a blockchain-based version of the country’s fiat currency, the yuan, known as the Digital Yuan (e-CNY). While the e-CNY has yet to launch nationwide, it’s currently in a pilot phase in 29 regions. It was also used as an official payment method during the 2022 Beijing Winter Olympics. 

Will the United States issue a CBDC? 

Although institutions like the Federal Reserve and the U.S. Department of the Treasury are exploring potential use cases for a CBDC, there’s no official timeline – or certainty – that it will materialize. Much of the speculation began in 2022 when the Fed released a report outlining considerations for possible USD CBDC. The report emphasized that any digital dollar must facilitate easy transfers through third-party financial institutions, include encryption to deter criminal activity, and incorporate identification verification systems (which would eliminate anonymity).

Despite this, the Fed has not announced specific plans for a pilot program (at the time of writing). According to its official website, the Fed “has made no decisions on whether to pursue or implement a central bank digital currency.” 

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.