Central banks operate at the center of monetary policy, controlling money supply and the creation of currencies. To understand the push towards new central bank digital currencies, consider the challenges of our current money supply.
Digital payments are nothing new, and there are some differences between our old idea of digital money, and these newly imagined central bank creations.
Fiat currencies (unbacked paper money) is difficult to track or recover, and nearly impossible to account for once in circulation. The American Institute for Economic Research estimates roughly a third of USD in supply is used for illegal activity and money laundering.
Coinage and bills are costly to manufacture, and when monetary stimulus is necessary, central banks often rely on commercial banks for distribution and lending. CBDC’s (Central Bank Digital Currencies) are poised to solve these legacy problems of fiat, and bring them into the 21st century.
Central banks have been studying the magic of something called blockchain, which removes several barriers and creates an easier pathway to greater fiscal agility.
A blockchain is a way of recording or “chaining” data in chunks called “blocks” using a network of computers. The network verifies and agrees on the data independently. Once agreement or consensus is reached, the data is sealed into a block. Simultaneously, a new block is created with a cryptographic proof called a hash from the previous block, and the process begins again. By this process, blockchain creates a list of transactions known as a ledger, and this ledger is verified and cannot be altered without consensus across the network.
Central bankers building a blockchain may solve many challenges and gain greater control of desired economic outcomes. Previously, transactions could be kept somewhat privately with cash, but with this new currency, all transactions will be available for audits of greater scrutiny by central authorities. Popular blockchains mostly leave control to democratic consensus on the network and limit central authority. Opposingly, centralized blockchains like CBDC’s will deliver greater control to government or non-governmental organizations, which could mean controlling users of the currency.
But why are nations and central banks now so interested in developing these centralized currencies?
Governments worldwide have been caught sleeping by the explosive growth of cryptocurrencies such as Bitcoin and stablecoins or smart contract platforms built without central authority or approval.
The capability of the consensus software belonging to these networks could possibly replace governments themselves in coming decades. Many blockchain networks are experimenting with democratic governance, programming for users the right to vote on the future direction of the network in an open and transparent way. This sounds similar to roles that have traditionally been reserved for governments, central banks and conglomerates.
Central banks have long held fiscal authority and desire to retain it. Centralized authority, and therefore a permissioned environment is not commonly found in the codebase of cryptocurrency favorites.
Bitcoin is a blockchain-based digital currency operated by a network of users without corporate, government, or central bank authority at its core. Smart contract platforms like Tezos, Ethereum, and others seek to create programmable money and value exchange tools to streamline or remove the need for central authority. Control or direction of the networks is instead left to the network of users. The preference of decentralization is deeply rooted within blockchain projects and cryptocurrencies, especially Defi (decentralized finance).
In 2020, the Bank of International Settlements released a document detailing the foundations and core features of central bank digital currencies. These CBDC’s will differ greatly from what we have seen in the world of cryptocurrency so far, and will likely discard the core principles of decentralization, censorship resistance, and privacy in favor of their opposites.
The concept of a stablecoin is attractive for the foundations of any CBDC because, like GUSD and USDC, central bank currency units will represent the equivalent value of USD held by the issuer. Central banks, however, can simply print currency units at will without backing since they both create and issue currency.
While the idea of money creation for a central bank seems straightforward, challenges arise with economic factors like inflation, and the velocity of money.
With CBDC’s, inflation or the expansion of the money supply is easily tracked. Accounting for circulating dollars and controlling inflation and growth become simpler and occur in real time.
Velocity of money is the speed and extent to which units of money move throughout the various levels of the economy from entity to entity. CBDC’s can adjust the yield rates for consumer savings and encourage spending or saving.
Because CBDC will have all of the traceability, immutability, and accountability of a blockchain while being controlled centrally, consumers might expect the wider economic frameworks to change.
Universal Basic Income will likely become increasingly common for consumers as governments acquire tools to encourage spending or savings on demand. These controls could more reliably be used to affect economic conditions.
Less will be spent on money creation, law enforcement, tax and crime with CBDC’s. Taxes will be cheaper to levy and programmed as an automatic deduction from transactions or income. Nations will have more cooperative diplomacy or aid, and the potential for a world-currency, under which CBDC’s operate, would be a near certainty.
Central banks would have a direct line to consumer accounts making most banks useless. Banks will radically transform their roles, if they remain relevant at all. Privacy will no longer favor cash users, but rather provide censorship and scrutiny to central banks and other CBDC beneficiaries. The consequences of removing third parties from industries like banking, insurance, and legal practice will be substantial.
A concerted push towards harnessing this new tech is unfolding. Tools of greater scrutiny, a less costly money supply, and infinite traceability are high on the list of central banks. Will individuals choose the centralized solutions of nations, banks, and the unelected? Could they instead choose the decentralized projects offering these benefits directly to consumers?