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The potential of cryptocurrency for central banks

(Image credit: Image Credit: Make-Someones-Day / Pixabay)

Every year the world becomes more digital, and finance services particularly benefit from advances in digital technology. 2020 has undoubtedly dealt us all with a severe blow, but the industries that can move on and operate in a virtual space are striving to do so. In some ways the global crisis has driven us to innovate and progress at a faster rate, and the proposed digital currencies for use in conjunction with central banks can be a solution to financial obstacles.

The challenges

In the middle of a pandemic, the exchange of physical items needs to be avoided so that disease-causing germs are not spread throughout the population. Banks in China have taken to measures of disinfecting cash with ultraviolet and heat treatment, and it has become a common practice for shops and restaurants to use disinfectant spray on banknotes. Due to the potential health risks of using cash currency, as well as the limits it poses on physical distancing, digital currencies have been given a new appeal in the context of a steadily increasing usage.

This means more people are making digital payments directly from their banks, or through an online payment system or e-wallet. These are commercial transactions that do not involve the use of a central bank, as they use a commercial bank or fintech startup. Commercial banks hold accounts with the central bank, but for administration purposes these accounts are limited in number and not available to every banking initiative.

Central banks are primarily concerned with production of physical cash for public use, although the amount needed is falling as digital payments are becoming more common. Cash is used less frequently in many Asian countries, and Sweden is slowly moving towards a cashless society, with a high proportion of the population not using cash at all.

Central banks are called on to intervene in times of crisis, such as with the quantitative easing that governments around the world were driven to in 2008 following the financial crisis. This has happened again in 2020, with central banks like the U.S. Federal Reserve providing financial relief to millions of people left without a source of income in the COVID-19 pandemic. In both cases of central bank intervention, funds are required to go through commercial banks, which can be time consuming, costly and inefficient. 

Blockchain technology

Blockchain is a technology that operates by consensus, and it is transparent and immutable. It is also known as Digital Ledger Technology (DLT) and it consists of individual blocks that are linked in a chain to the next block with its cryptographic hash. Whereas a public blockchain network is open for anyone to participate, a private or consortium blockchain network is only for those given special permission.

Blockchain is a recently introduced technology that powers the use of cryptocurrencies, such as Bitcoin, Ethereum and EOS. Cryptocurrency uses a consensus protocol for exchanging credit. It also has a wide range of other applications with the potential to revolutionize industries and business fields. In addition to cryptocurrency it has particular relevance to methods of security, such as smart contracts and identity management.

Cryptocurrencies can be either centralized or decentralized. The main difference here is that with centralized currencies transactions are controlled by the owner of the exchange, but decentralized currencies exclude the use of an intermediary. Bitcoin is an example of a centralized currency, while Facebook’s Libra is a decentralized currency. Currently, centralized cryptocurrencies form the large majority of all cryptocurrencies, but experts predict this to change in the next five years. Libra is set to play a major role as a powerful decentralized currency that anyone in the world can gain access to.

The volume of users of a cryptocurrency determines its price, as this relates to the value of the community, with more users causing a higher price. As Bitcoin was the first cryptocurrency when it was launched in 2009, it has had more time to develop users and become by far the most valuable cryptocurrency. But cryptocurrencies can be extremely volatile, which is a factor that keeps them from being adopted as a proper currency. A possible solution to this could be the use of stablecoin, which is a cryptocurrency that is pegged to fiat money, a commodity or another cryptocurrency. This is a characteristic that is proposed for Facebook’s Libra, which is why many onlookers have high expectations for the new currency.

As a means of exchanging money, the popularity of cryptocurrency has been continually growing, with more interest from large corporations, such as Visa and PayPal, and rising prices.   

Central bank digital currency

The idea of a Central Bank Digital Currency (CBDCs), or digital fiat currency, could provide the solution to a number of systemic problems.

CBDCs digitize the monetary system making it more efficient and easier to access funds, and the considerable intermediary costs of managing and transferring cash can be avoided. While cryptocurrencies are generally decentralized and volatile, CBDCs are centrally controlled and backed by the government, which means there is greater trust and therefore more stability. Monetary policies will also flow more directly and seamlessly through a digital currency that is not hindered by third parties, and the public is more accustomed to a cashless system.

People will either have direct access to accounts with the central bank, or through partnerships with commercial banks. Increased possibilities for financial inclusion are an extra incentive, as billions of people around the world do not currently have access to even basic financial services. CBDC initiatives have the potential to provide secure access to money through a mobile device.

The idea of a CBDC was first inspired by Bitcoin and other cryptocurrencies, and has been considered by various governments in the last five years. Countries in Africa, such as Ghana and Rwanda are researching or investigating the potential use of a CBDC to provide financial services to an unbanked population. Most countries are still in the research stages, but France has already piloted a CBDC transaction, and Sweden is currently carrying out a one-year trial of the new e-krona, built on the Corda DLT platform.

It is still early days for central bank digital currencies, but the sooner banks and financial services can anticipate and prepare for the move, the sooner a seamless transition can be made. There are still problems to overcome, such as regulatory processes and cybersecurity risks, but provided CBDCs can be trialed and monitored then these can be handled. Digital currencies are quickly growing in use, and the role of central banks in digital currency will help to grow a more stable, efficient and democratized system.

Zak Gottlieb, Business Development Manager, Computers In The City