When Bitcoin launched in 2008 and Ethereum started the altcoin boom through its 2015 ICO, not many people gave this new "digital currencies" much attention. But subsequent increases in the popularity of cryptocurrencies have given everyone, including governments, a pause.
Now, countries are planning to launch digital versions of their currencies, called central bank digital currencies (CBDCs). While the US is mulling a digital dollar, countries like China and the Bahamas have piloted CBDCs already. Even less-developed nations have gotten into the game.
If these signs are anything to go by, then CBDCs are inevitable. We're slowly accelerating towards a cashless society, and CBDCs will be the new pillars of the economy.
However, just because something is popular doesn't mean it's necessarily good—and this applies to CBDCs. While many have talked up the benefits of government-backed digital currencies, they leave out crucial information about how these new currencies will work.
And, as they say, the devil is in the details.
This article explores the meaning and implications of CBDCs while touching on the reasons for their popularity. I’ll also consider some of the risks of replacing fiat money with centralized digital currencies.
A CBDC is a digital version of a country's currency that’s available for households and businesses to use for payments or storing value. CBDCs are created and issued by a country’s central bank, which is why they are called “Central Bank Digital Currencies.”
CBDCs are backed by the government and pegged to the value of the national currency. This makes a CBDC different from a cryptocurrency, which isn’t backed by any institution or asset. Since CBDCs have “legal tender” status, you can buy goods, pay for services, or settle your taxes with them—things you cannot do with crypto yet.
You can think of CBDCs as “stablecoins,” which are cryptocurrencies that derive value from a real-world asset like the dollar. Stablecoins like Tether (USDT) and Binance USD (BUSD) can be bought and redeemed like regular dollars and offer investors protection against crypto’s volatile price swings.
Like cryptocurrencies, CBDCs use Distributed Ledger Technology (DLT) to facilitate supply of money and transaction monitoring. Also, central banks may integrate permit payment services with the ledger to facilitate easier transactions.
The shift towards a cashless society had been slowly happening, well before the COVID-19 pandemic. But, with lockdowns keeping people indoors, the demand for cashless, digital payments systems surged.
And then Libra happened.
Before its demise, Libra was a cryptocurrency project floated by Mark Zuckerberg-owned Facebook. Unlike other cryptocurrency projects, Libra was the first visible effort by a private company to launch its own currency.
As expected, governments criticized the Libra project and pressured payments providers to withdraw support for Libra payments. While Libra eventually died quietly, it forced governments to see the threat of privately controlled currencies to state monopoly of financial systems.
Many world powers started taking the idea of virtual currencies seriously, and the Bahamas launched the world’s first CBDC (the Sand Dollar) in 2020. More countries have since followed suit, including China which introduced a “digital yuan” at this year’s Winter Olympics.
This timeline of events reveals the first and most important reason for the existence of CBDCs: increasing government control of money. There may be other reasons for using CBDCs, but that doesn’t change their status as tools of state monetary control.
Supporters of minting tokenized versions of state currencies claim they have other benefits.
For example, digital fiat-backed currencies can simplify payments for individuals and businesses. They’d also promote financial inclusion by allowing unbanked individuals to transact without enduring cumbersome registration processes.
CBDCs can ease the implementation of monetary policies—for example, destroying currency tokens in circulation would be enough to control inflation. Moreover, increased surveillance of money flows in an economy will prevent tax evasion, reduce corruption, and disrupt the funding of illicit activities, like drug trade or terrorism.
However, for all their benefits, CBDCs have many risks that are too serious to be ignored.
Cryptocurrencies like Bitcoin (BTC) and Ether became popular because they are anonymous, censorship-resistant, secure, and decentralized. And no one can unilaterally determine the supply of bitcoin or ether, making them a hedge against inflation.
With CBDCs, the rules are different.
These “government-issued cryptocurrencies” belong to the government, and it can set rules for their circulation, use, and availability. Maybe you don’t realize it, but centralized control of digital currencies brings up many problems:
CBDCs will usher in unprecedented levels of spying on the privacy of citizens. Every purchase, every transfer, every payment can and will be logged in a government database for both benign (taxes) and non-benign (financial surveillance) reasons.
Governments will become Big Brother, tracking who is doing what with money in the country. If it wants, a government can easily block certain transactions it deems “illegal.” This could be anything from buying legal marijuana, paying an informal worker, or even remitting money to your family in blacklisted countries.
Cryptocurrencies provide the opportunity to transact directly with any party without anyone interfering. CBDCs threaten to turn this upside down and increase government oversight over monetary exchanges between individual.
Most cryptocurrencies run on public blockchains sustained by distributed networks of computers (nodes). The decentralized nature of a public blockchain network allows it to keep operating even if a few nodes malfunction or suffer attacks.
Hacking a cryptocurrency requires controlling every node running on the network—a difficult, cost-ineffective, and impractical task. That’s why cryptocurrencies like Bitcoin and Ether have remained secure for years.
CBDCs will be fully centralized and hosted on private or permissioned blockchains. While these have better transaction speeds, they create single points of failure. Malicious actors only need to breach a few servers, and suddenly, they can control the entire country’s monetary supply.
Perhaps CBDC supporters have forgotten, but decentralization is the point of blockchain technology. A centralized digital currency exacerbates the very problems, like double-spending, which cryptocurrencies were designed to solve.
To achieve full functionality, CBDCs will likely expand on existing digital payment systems, such as Google Pay, Venmo, and Apple Pay. These apps will integrate into central bank deposits, allowing users to spend and send e-money via apps, chats, and messages.
Big Tech companies will become the new banking institutions, powering transactions all over the world. It’ll also allow service providers to collect your data and store it in centralized databases for corporate use.
Of course, there are downsides to companies harvesting personal data. For instance, companies are often criticized for leaking, selling, and mismanaging user information. Google is particularly notorious for selling user data to advertisers and fueling the ad targeting market.
This goes without saying, but centralized data storages are honeypots for malicious actors. Now, a hack on Google’s servers might probably lead to varying degrees of identity theft. In the future, hackers will steal your identity and your entire wallet balance.
A purported benefit of CBDCs is that they make it easier to introduce and enforce fiscal policies. Governments can easily mint new currency tokens to counter deflationary trends in the economy. Tax offices will also find it easier to track money flows and deduct taxes automatically.
While all that sounds good in theory, it has several implications for financial stability.
Since central banks control the supply of CBDCs, inflation is a real risk. Heads of central banks, drunk on the Modern Monetary Theory (MMT) Kool-Aid, can simply press a button and inflate the circulating supply of digital currencies.
This will result in massive hyperinflation, where currencies become worthless and prices go through the roof. You think the runaway inflation in Venezuela and Zimbabwe was bad? Wait till your central bank starts minting currencies at a whim.
If CBDCs allow governments to enforce positive fiscal policies, then they can be used to enforce negative policies as well. Implementing negative interest rates on currency holders is certainly easier when you can program money however you like it. And that’s just one possibility; we don’t know other policies authorities will force citizens to accept through digital currencies.
A CBDC dramatically increases government control of cash flows in the economy. This may lead to the “weaponization of money,” where the government coerces individuals and businesses by cutting off their money supply.
Currently, political officials have to rely on third parties, such as banks and payments providers, to enforce financial discrimination policies. An example is the Nigerian government forcing banks to block donations to #EndSARS movements protesting police brutality.
With CBDCs, national governments can freeze monetary assets without leaning on banks. Criticized the ruling party or organized a protest? Too bad, ‘cause you’re about to get frozen out of the monetary system.
Already, countries like China have “social credit systems” that determine your access to certain services, based on your political views, shopping habits, online activity, work history, and other attributes. Pairing social credit systems with CBDCs means governments can “punish” those who contravene its rules by stopping them from spending money.
If that sounds like a dystopian nightmare to you, then you’re starting to see the risks of CBDCs.
So far, I’ve focused mainly on the problems CBDCs pose to individuals and businesses. But CBDCs are also problematic for banks and other large financial institutions.
The likeliest iteration of a CBDC system is one where the country’s central bank issues digital currencies directly to consumers and secures their deposits. Central banks would replace private banks, destroying the entire commercial banking system.
Even a hybrid approach that puts central banks and commercial banks in control of CBDC supply will still cause problems. Citizens may feel safer keeping their funds with the central bank than private banks, leading to recurring bank runs. What do you think will happen to the economy when every bank folds up?
With around 80% of central banks exploring CBDCs, you can expect them to arrive sooner than you expect. And you’ll have no choice but to use them—how else are you going to pay for stuff in a cashless society?
The upside to introducing CBDCs is that the popularity of cryptocurrencies will increase. As people desire censorship-resistant money free of state control, the value of Bitcoin, Ether, and other cryptos will skyrocket.
Instead of killing crypto, CBDCs might just spark mass adoption of cryptocurrencies. To borrow Shakespeare’s famous expression: “All’s well that ends well.”
Also published here