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Cryptocurrencies or Central Bank Issued Digital Currency? Perhaps Both

Feb 22, 2019

High Machine Learning Accuracy Rates for CryptocurrenciesHigh Machine Learning Accuracy Rates for Cryptocurrencies
High Machine Learning Accuracy Rates for CryptocurrenciesHigh Machine Learning Accuracy Rates for Cryptocurrencies

CBDC: More than Meets the Eye

Central Bank Issued Digital Currency (CBDC) has been a prominent topic debated among traditional economists and cryptocurrency pundits alike since blockchain technology began to gain popularity in the early 2010s. But why? What are the benefits? Already in the world's current state, at least 92% of money is in some way digital while countless solutions already exist to address problems created by our existing financial system, right? CBDC sounds great at face value, but integrating the technology into financial systems is far more complicated than simply using it to replace cash. Despite this, a properly executed CBDC system may be the solution so many are waiting for. For a decade, crypto pundits have hailed cryptocurrencies as the solution to trustless financial systems and global financial inclusion. A meticulously thought-out and highly-orchestrated roll out of CBDC systems, however, could prove the answer to trustless financial systems and global financial inclusion that so many thought cryptocurrencies would solve.

CBDC at a Glance

In 2009 following the global financial crisis, Satoshi Nakamoto invented the world’s first blockchain-based currency, Bitcoin (BTC), to serve as a decentralized store of value across the globe. In contrast, CBDC is a currency based on blockchain but instead controlled by a central bank, also known as a centralized authority. Like traditional fiat currencies, CBDCs are meant to accomplish three main goals: to serve as a means of payment; to serve as a unit of account; and to serve as a store of value. The most appealing prospects of CBDC, however, is its potential application in boosting global financial inclusion, aiding economic growth, and maximizing transaction efficiencies. 

While conversations regarding CBDC have occurred amongst central bankers since as early as 2014, discussions notably ramped up in 2018. In the last year alone, both the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) published detailed, comprehensive reports that evaluate the advantages, implications, and types of CBDC. In July 2018, Banco Central Do Brasil, Brazil’s central bank, published a working paper discussing the prospect of a CBDC in South America’s largest economy. More recently in October 2018, the Bank of Canada, Payments Canada, TMX Group, Accenture, and R3 partnered to publish Project Jasper’s Phase 3 white paper, a collaborative project evaluating the potential role of distributed ledger technology in the Canadian financial system -- a notable portion of the white paper discusses the prospect of CBDC in Canada. Soon after in November 2018, the Bank of Canada, the Bank of England, and the Monetary Authority of Singapore published a joint report analyzing approaches to cross-border settlement systems, many of which involve integrated CBDCs.  


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Token-Based CBDC vs. Account-Based CBDC

When discussing CBDCs it is important to note that two different types exist; account-based CBDC and token-based CBDC. An account-based CBDC system would closely resemble transactions between commercial bank depositors in today’s financial system while a token-based CBDC system would more closely resemble how today’s cryptocurrencies are transferred between users.  

In an account-based CBDC system, users do not hold actual digital assets or tokens in their account. Instead, payments are made via the transfer of claims recorded on an account. Because account-based CBDC systems require several information data points to be verified to complete a transaction, for example, sufficient funds and verifiable account ownership, anonymity would likely not exist. Account-based CBDC systems would likely heighten risks associated with financial institutions like bank runs while increasing funding costs for deposit-taking institutions. If properly executed, however, account-based CBDC systems would mitigate these risks and facilitate large-scale financial inclusion. 

Conversely, in a token-based CBDC system, payments are made via the actual transfer of an object, be it a token or other digital asset. In a token-based CBDC system, users hold distinguishable tokens in their accounts. When a payment is made to another user in this system, the distinguishable tokens are transferred to that user’s account. A properly executed token-based CBDC system could facilitate anonymity, however, validating that tokens are not counterfeit would require some form of external verification. 

In the graphic below provided by the IMF, the key differences between account-based CBDC and token-based CBDC through the transaction process are depicted.  


Tying CBDC to Cryptocurrencies

A notable portion of cryptocurrency industry pundits vigorously oppose CBDCs, seeing them as an enemy to the ideals of cryptocurrencies. Many would argue that adoption CBDCs or cryptocurrencies are a zero-sum game; if CBDCs achieve mainstream adoption, cryptocurrencies will not, and vice versa. While this may be true in a sense, a more likely scenario would be that adoption of one drives adoption of the other.  

In today’s financial ecosystem, a vast number of central bank currencies co-exist alongside a plethora of different financial instruments and systems; gold is still seen as a store of value, bonds are used to track bearer obligations, and banks transact internationally over the SWIFT network. What do all of these financial instruments and systems have in common? Their existence serves a purpose and adds some form of value to the global financial system.  

Cryptocurrencies would undoubtedly survive mainstream adoption of CBDCs, but perhaps not in their current form. In today’s cryptocurrency market multiple coins and networks exist that aim to serve the same purpose or solve the same problem. Decentralized application (DApp) networks Ethereum (ETH) and Stellar (XLM), for example, are both top ten cryptocurrencies by market capitalization even though they essentially serve the same purpose. A mainstream switch to CBDC in global financial markets would likely invoke Darwin’s, “Survival of the Fittest,” and leave only cryptocurrencies with the strongest networks and highest value-added untouched. Further, these cryptocurrencies would not only survive, they would likely flourish, in terms of adoption, as long as they continue to be the best at serving their respective purpose.  

On the flip side, mainstream adoption of cryptocurrencies would almost undoubtedly force central banks to push forward with CBDCs. In an environment where cryptocurrencies are adopted by a majority of individuals, central banks would need to put forward a CBDC to participate in the global financial ecosystem. As the cryptocurrency industry and blockchain technology continue to innovate, central bankers will continue to explore the concept of CBDC. In the meantime, crypto holders should warm up to the idea of a financial ecosystem where cryptocurrencies and CBDCs exist in harmony; it is likely what we will see in the long-term future.