Bitcoin, Ether, Ripple: You may already be familiar with these names from the crypto world – but how much do you know about how these digital assets work? Let’s start with the basics: The terms ‘digital currency’ or ‘cryptocurrency’ refer to a specific type of money that only exists in electronic form and is stored in applications or electronic ‘wallets’, which are accessed exclusively via electronic devices. To prevent them being counterfeited or duplicated, digital currencies are secured using an encryption method – with the currency details stored using distributed ledger technology (DLT). Bitcoin and its counterparts rely on a decentralised form of DLT called blockchain. So far, so technical.
Fad or future?
The use of digital payment methods has accelerated massively in recent times. But if you consider that less than 1% of all global digital payments were made using privately issued digital currencies such as Bitcoin as of end-2019, you might conclude that crypto is still very much in its infancy. And it is true that restrictions on their use for everyday payments, a lack of regulation and concerns about the potential misuse of digital currencies have so far hampered their transition to a mainstream form of digital payment – without even mentioning challenges such as their high volatility and limited liquidity.
However, that is only one side of the coin. Let’s not forget that the crypto scene is renowned for its speed of innovation – and looking at developments last year, there is no denying that the adoption of crypto as a payment method is gathering steam. In 2020, for example, the payment platform company BitPay enabled companies such as AT&T to accept payments in Bitcoin. Last October, the fintech giant PayPal announced that its customers will be able to use cryptocurrencies to shop with the 26 million merchants in its network from early 2021. Perhaps even more striking is the announcement by the Swiss Canton of Zug that it will accept tax payments in Bitcoin or Ether from 2021. Social media companies are also jumping on board, with Facebook’s launch of its own digital currency Libra.
Against this backdrop and in response to changes in consumer payment trends, central banks are showing a growing interest in the technology behind cryptocurrencies and are exploring whether it could help them develop a complement to existing forms of digital payments. While both central bank digital currencies (CBDCs) and cryptocurrencies rely on DLT, there are significant differences between them. For instance, cryptocurrencies are privately issued and not backed by assets or regulated by governments, whereas CBDCs are issued by a country’s central bank and backed by reserves and they are subject to regulation. In addition, with CBDCs, the money supply is controlled by central banks, while cryptocurrencies have a defined and limited supply. But the most striking difference of all is that while more than 5,000 cryptocurrencies already exist, there is today only one CBDC – in the Bahamas.
Pros and cons of CBDCs
A lively debate is now underway about the possible pros and cons of CDBCs. There are several compelling arguments in favour of them. First, in economies where a large proportion of payment transactions are already executed digitally, central banks see the potential of CBDCs in ensuring that customers continue to have access to a peer-to-peer means of payment that is backed by reserves and has the same fundamental characteristics of cash as a unit and store of value. Second, CBDCs could theoretically foster financial inclusion in regions with a limited formal banking infrastructure. Further, the issuance of a wholesale CBDC available exclusively to financial institutions as a means of settling payments could speed up the entire settlement process.
The flip side is that although the issuance of CBDCs could provide central banks with an additional way to inject money into the economy or indeed withdraw it, there is also a risk that this type of digital currency could undermine the financial stability of commercial banks. And while CBDCs would primarily be issued for domestic use, there is a threat that if adopted across borders, a CBDC could dilute a nation’s monetary sovereignty by reducing the attractiveness of its local currency – potentially accelerating dollarisation. And third, CBDCs would need to strike a balance between complying with rules and regulations and protecting the data privacy of their users.
The money of the future?
The bottom line is that it is not yet certain whether central banks will venture down the crypto path in the near future. And in reality, it is unlikely that cash will cease to exist as the safest form of money any time soon. Nevertheless, if central banks decide to create their own digital currencies, attention will need to be focused on both the security and stability of this form of money and the convenience and accessibility of electronic payments made with CBDCs.