About CBDCs


Tom breaks down Central Bank Digital Currencies and why they are not the same as cryptocurrency.

Featuring Tom Merritt.



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Episode Transcript:

I’ve barely wrapped my head around Bitcoin and now you tell me the government is getting into it?
There’s something called Seabee Geebies or CBDCs??
Is cash going away?
Are you confused?
Don’t be.
Let’s help you Know a Little more about Central Bank Digital Currencies or CBDCs

Central Bank Digital Currencies or CBDCs are digital currencies issued by a government institution– usually a central bank– an alternative to– not a replacement for– an alternative to coins or printed money. They’re sometimes called digital base money or digital fiat currency. Fiat currency is the name for the money most governments issue. Side note, fiat means issued by order or decree. The term fiat money arose to distinguish it from money backed by something like gold or silver.
CBDCs are often compared to cryptocurrencies because they’re digital, but that’s a confusing comparison because they have different aims. Cryptocurrencies are generally meant to be independent, and often are decentralized, where no one entity controls the servers the system runs on. Even when a cryptocurrency is centralized it’s generally meant to be independent of governmental institutions. And cryptocurrencies are often seen as an investment. CBDCs are no more or less of an investment than the country’s fiat currency.
CBDCs are also different from a particular kind of cryptocurrency called a stable coin. Stable coins are usually linked to a stable fiat currency so the value doesn’t fluctuate any more than the currency it’s based on. One stable coin linked to the Euro would always be worth one Euro. These are closer to a CBDC but they’re not issued by the central bank.
So I think about government digital currency less as a government form of cryptocurrency and more like a digital driver’s license or a virtual transit pass. It’s something the government creates in a digital form instead of physical form.
And most of the CBDCs in development don’t use a blockchain or any kind of distributed ledger. In many ways they’re more like the money in your bank account than they are like bitcoin. Except even though you only see your bank account money as a number on your bank’s website or app, somewhere– allegedly– there’s a stack of paper money representing the balances in that bank. With CBDCs there would not be.The digital currency would be the same as the paper currency not just a digital record that it exists.
So if they aren’t cryptocurrencies exactly and they aren’t necessarily using a blockchain and aren’t even backed by paper money what are they and how do you get off calling them money?
Let’s figure out how this works.
Whatever system a central bank uses, a CBDC will rely on the consumer having a digital wallet. This will most often be done in software on a mobile device, but could also be done in hardware like a smart card or some other kind of smart dongle.
The wallet would authenticate the user some robust way. This could be by PIN, password, or biometrics. Most CBDCs contemplate using the FIDO alliance password-less strong authentication. See our episode on FIDO for more on that.
Wallets would also need to authenticate parties in a transaction, whether sending or receiving currency. This can be done with public and private key exchanges (we have an episode on that too) between two wallets or with a central database.
A few central banks are considering using a distributed ledger like a blockchain. It would still be centrally controlled but would include the security of the blockchain and be an easy way to get a system running. But it also introduces some complexity that’s not necessary for this system. You don’t need to avoid centralized control, which is one of the main aims of a blockchain.
So most Central Bank Digital Currencies being developed use a token-based system. Tokens are protected with strong encryption from being duplicated– kind of like Bitcoin– and then recorded in a database under the control of the government, usually the central bank. The bank itself may run the database or it may contract a private entity to do it for them, but the government is in charge, not the private entity.
The database keeps a record of any entity, people, companies, government organizations etc, that hold the digital currency. So you could have an account which tracks the balance in your CBDC wallet from which you could pay others or accept payments or deposits.
There isn’t one settled way to run a CBDC yet. One thing they all have in common though, is the need for strong cryptography to keep each unit of the currency from being copyable. And as far as payments and transactions, there’s a lot of security already built into the current system– like in point of sale units– that can be adapted for CBDCs.
That sounds like a lot of work. Why do that? Why not just keep the system we have now? It works, right?
Well CBDCs, like blockchain-based cryptocurrencies that inspired them, would be way more efficient. Right now when you pay someone using a bank or a credit card there are dozens of entities involved in the transaction. The point of sale system talks to a credit authorization system which communicates with a payment processor which talks to a clearing house which talks to a bank. And that’s a major oversimplification. That’s why money transfers can take up to three days.
With a CBDC there’s one entity, the central bank, that does the transfer, in real time from you to the person you’re paying. This reduces risk because you know immediately if the payment was successful. It makes accounting easier because you don’t have a lot of stuff you’re waiting to clear through the banking system. And it eliminates fees since there are no organizations in the middle taking a cut.
And because your account/wallet holds your actual digital currency a run on the bank would not cause your money to be unavailable because the cash isn’t in the vault.
Another benefit is that CBDCs are often promoted as a solution for the unbanked. Banks need to develop and maintain infrastructure to provide access to its financial system. This involves verifying identities, creating credit cards and debit cards, offering ATMs etc. CBDCs could just be run on a phone with a connection to the CBDC database. So instead of having to apply for a bank account, every citizen could get a wallet or account from the central bank through a phone. This could be done with an app but as has been shown by systems like M-Pesa in Kenya could also operate over text messaging. 89.9% of people own at least one mobile phone, that’s 7.1 billion people. And even for those who don’t have or don’t want to use a phone for CBDCs, cards similar to transit cards can be created to act as digital wallets for the digital currency.
And then there’s a benefit that’s also a downside. Tracking. Every transaction is recorded which helps governments collect taxes and combat crimes like money laundering. But also means the government knows every transaction making people uneasy, especially if they don’t trust their government.
Another downside with an upside, is that CBDCs could take away a kind of revenue from banks, causing them to have to shift their business models. A downside for the banking industry but possibly an upside for consumers who might benefit from increased banking competition to get you to use them for deposits and loans. They’d have to offer you new features to convince you, versus now where you feel like you have to use them because your alternative is sticking your money in a mattress or burying it in a jar out back.
And of course the one main downside to CBDCs, centralized control. Bad actors within a government might be tempted to abuse their control to punish political opponents or activists by removing money or access. More often and more likely are the privacy and security issues faced by ISPs and current banks. The central bank would become a prime target for attackers looking to crack into the database and steal money or information.
Up until now I’ve been describing what are called Retail CBDCs. The money us regular folks use in day to day life. There’s also something called a Wholesale CBDC. These would be used for payments between central banks or between any banks. You think the system is complicated for you buying that Violet Crumble at the Aldi? It’s way more complicated for banks to exchange money across borders. CBDCs could be used to make it easier for banks to do cross-border transfers.
In September, central banks in Australia, Singapore, Malaysia and South Africa started testing a system to use CBDCs to make cross-border transactions cheaper and easier between those countries.
And the Bank for International Settlements which handles this issue for fiat currencies is also exploring using CBDCs for cross-border payments with the central banks of China, Hong Kong, Thailand and the UAE.
So we know how they kind of work. And we know some big fancy international banking is testing them. When can I get a wallet?
I mean seriously. Is any country actually doing this for its citizens?
Yes. And it’s not El Salvador. You may have heard that El Salvador adopted Bitcoin as an official currency. That is not a Central Bank Digital Currency because it’s not issued by a central bank. It’s no different than El Salvador saying Canadian Tire Bucks are now they’re official currency. It’s the government giving a currency they are not in control of the official blessing to pay for things with it.
But it’s not a Central Bank Digital Currency.
The Bahamas get the credit for the first Central Bank Digital Currency. The Sand Dollar is the official digital version of the Bahamian dollar, issued by the Central Bank of the Bahamas in collaboration with MasterCard and Island Pay. It was officially deployed in October 2020.
With 700 islands, moving actual cash around the Bahamas is costly and time-consuming. You have to put it on boats and stuff. The hope is that disbursements using the sand dollar will reduce the need to move actual paper notes by boat or otherwise.
5 other Caribbean islands have followed suit, including St. Kitts and Nevis, Antigua and Barbuda, Saint Lucia, and Grenada.
China is also fairly well along in a central bank Digital currency
China is the biggest country that has an active test of a working CBDC, the digital RMB for domestic use and digital Yuan for international use. It launched its test programs in 2020.
China’s CBDC exists on a phone or digital card and does not need an active internet connection to make transactions, though it does need internet to access accounts. Some of China’s tests of its digital currency set expiration dates to encourage spending. But they don’t usually do that. And China replaces one unit of physical currency for every digital unit it releases, keeping the money supply the same. China’s CBDCs are issued by the People’s Bank of China to a few private banks for disbursement, keeping banks in the loop.
China has conducted multiple tests of CBDCs in many cities like Shanghai, Shenzhen and Beijing, giving citizens free grants of small amounts to spend in a few participating test locations including Mcdonald’s, Subway, and Starbucks. The big test is expected to happen at the 2022 Winter Olympics in Beijing which will feature a pilot program with a wide national and international footprint for the first time.
And that’s about it. While around 90% of government central banks are investigating or developing digital currencies, there aren’t many who have launched them.
For instance MIT and the Boston Fed are undertaking Project Hamilton to research and test a FedCoin for the US. The Bank of England has created a CBDC task force and the EU launched a two-year investigation into a digital Euro project in July 2021. But none of them are coming anytime soon.
So there you have it. Central Bank Digital Currencies are something central banks around the world would someday like to issue as an alternative to paper notes and coins, that you could hold and spend in digital cards or phone apps for easy efficient spending and saving.
In other words I hope now you know a little more about CBDCs.