Digital or Crypto: What is the future of our monetary _? Understand Central Bank Digital Currencies

2021-06-09, 07:05

Image Source: BBC

Following Shenzhen, Suzhou, and Beijing, the next stop for e-CNY (or DC/EP) is Shanghai. On June 4th, the Shanghai Municipal Government stated that it would draw 350,000 e-CNY red envelopes, each at 55 yuan, with a total of 19.25 million. This red envelope issuance is a routine test of China’s digital currency. During the validity period, people can use red envelopes for non-threshold consumption at certain merchants and relevant online platforms. Since April last year, e-CNY has been piloted in many cities in China, and the total amount of red envelopes issued has exceeded 150 million Yuan.

China is the first to start digital currency research and pilot projects. Other central bank digital currencies are also developing rapidly in many countries. According to data from the Bank for International Settlements, more than 60 countries around the world are currently conducting central bank digital currency research. The e-Krona issued by the Riksbank (Sweden's central bank) has entered the testing phase. The Bahamas have provided the digital currency named "Sand Dollar" to all citizens of the country. The Federal Reserve has also launched an exchangeable equivalent to the U.S. dollar, Fedcoin, as a retail central bank digital currency.

Why are central banks developing digital currencies (CBDC)? What changes will its development bring to our lives? Will CBDC become mainstream in the future? What are the differences between central bank digital currencies and cryptocurrencies, such as Bitcoin? Does this mean that central banks have entered the market to challenge cryptocurrencies?

What is a Central Bank Digital Currency

To answer the above questions, we must first understand what CBDC is. Take the e-CNY issued by the People’s Bank of China as an example. At the 2nd Bund Finance Summit in Shanghai, Mu Changchun, director of the China Digital Currency Research Institute, said: “E-CNY is a legal digital currency issued by the People’s Bank of China. It is operated by designated institutions and redeemed by the public in the equivalent of banknotes and coins." This statement explains the nature of e-CNY and CBDC.

CBDC is a legal digital currency issued by the central bank of each country and has the status of Fiat Money. In simple terms, CBDC is a digitized paper currency and is intended to replace cash or to complement the role of cash. The issuance of cash involves minting, circulation, and recycling, which has economic and environmental costs. A direct advantage of CBDC is that it reduces the costs of the current monetary system. In addition, central bank digital currencies can achieve what is called "controlled anonymity" due to various advanced technologies.

In economics, currency can be divided into several different levels. The first level is M0, which refers to the base currency issued by the central bank. It exists in two forms: cash circulating in the market and the reserves of the treasury at the bank . The second level M1 (narrow money) includes not only M0, but also current deposits in banks. The third level M2 (broad money) is based on M1 plus time deposits and other less liquid assets. From M0 to M1 and then to M2, liquidity gradually weakens. The total amount increased reflects the function of the banking system to "create money". In terms of currency stratification, the central bank’s base currency and cash both belong to M0, while the balances on Alipay and WeChat Pay are M2.

The e-CNY adopts a two-tier operating system. The People's Bank of China needs to exchange the digital currency with the bank, and then the bank gives it to the public. E-CNY’s exchange and redemption (similar to deposit and cash withdrawal) does not charge service fees. At present, China's six major state-owned banks have begun to promote e-CNY currency wallets. In addition, two private-owned banks, Zhejiang E-Commerce Bank (Alipay) and WeBank (WeChat) are also developing their e-CNY wallets. People can apply for and download a wallet without needing a bank card, and they can hold e-CNY like cash. In terms of mobile payment experience, e-CNY is very similar to online payment systems, which are currently popular in China. Compared with current online payment systems, e-CNY transactions have many advantages. For online payment methods using Alipay and WeChat, every transaction needs to be sent through the bank to establish a system for low-level account settlements. Since the e-CNY is a basic digital form of currency, it can be used for direct peer-to-peer transactions. Using it to conduct transactions is like any other medium of exchange. In addition, using e-CNY can also achieve so-called “dual offline payments”, which will allow payments to be made even when both the payor and the payee are offline.

Therefore, the implementation of e-CNY in China may not encounter much resistance. E-CNY has no intention of replacing mobile payment methods such as Alipay and WeChat, but aims to cooperate with existing payment tools. Alipay and WeChat will most likely add an e-CNY wallet. The original ways of financial services will not change much.

Technically, e-CNY uses certain technologies attributed to cryptocurrency. Each denomination has a unique identification, like the number on cash notes, which is similar to cryptocurrency. "Printing" e-CNY means that the central bank uses an encryption algorithm to generate digital strings with signatures. During a transaction, both parties of the transaction have a certain degree of anonymity. The transaction data is processed through the Hash algorithm, making it difficult for commercial banks and institutions to track the transfer. It differs from Bitcoin. The public key of the e-CNY is stored in the central bank, and the central bank's backend can track the transaction. Therefore, it’s a kind of "controllable anonymity" on the frontend and less so on the backend. This makes it difficult for commercial institutions to collect users' private transaction data. However, the central bank can strengthen the supervision of fund transfers and improve the ability to combat corruption, money laundering, tax evasion and other illegal crimes.

The impact of e-CNY may revolve around macro-control and big data. The promotion of the e-CNY has given the central bank more room to implement monetary and fiscal policies. In an era when everyone has their own digital wallet, it is more likely we see low or even zero interest rates to stimulate the economy. The central bank may also directly provide liquidity support to low-income groups and small or medium enterprises. In terms of data collection of payment systems, the dominance of Ali and Tencent will also be dismantled.

However, the e-CNY differs from the CBDC issued by various countries. For example, the Swedish e-krona is also issued by the Central Bank, but its technology uses distributed ledger technology.

CBDC and Cryptocurrency

In 1960, Belgian-American economist Robert Triffin put forward the so-called "Triffin Dilemma": If the US dollar wants to maintain its status as a world reserve currency, it must maintain a current account deficit, allowing other countries to obtain enough dollars. If the dollar continues to flow out and the US deficit continues to grow, confidence of countries that hold the dollar may decline and the international status of the dollar may also decline. In 2008, the subprime mortgage crisis broke out in the United States and harmed the global economy. The sustainability of the U.S. dollar's function as an international reserve currency began to be discussed by the international community. In 2009, when Bitcoin came out, it was the first time encryption technologies such as blockchain aimed to achieve features such as anonymity, decentralization, with a fixed total supply. These concepts have been welcomed by the global market.

The various novel features of cryptocurrency have brought new possibilities to the modern currency system. When talking about currency, people are actually referring to trust. In ancient times, people used shells as currency because they believed that every member was willing to accept shells. Later, people used precious metals such as gold as currency because the production of these precious metals was very limited, and these metals had practical purposes such as decoration, so as to balance price fluctuations. Later, when the sovereign currency was decoupled from gold, people believed that national sovereignty could endorse the currency, and people kept the currency price relatively stable. Cryptocurrencies such as Bitcoin are trying to redefine trust by using technology and cryptography.

Inspired by Bitcoin, central banks of various countries have gradually turned their attention to digital currency. In 2014, Zhou Xiaochuan, the governor of the People's Bank of China mentioned the research and development of e-CNY in internal discussions. In June 2019, Facebook released the Libra white paper, aiming to establish a stable currency linked to a basket of sovereign currencies. Once launched, Libra can be used as a cross-border payment. Libra has been questioned by regulatory agencies in various countries, but it has also further promoted the attention of central banks to digital currencies.

Cryptocurrencies are generally considered to have two main attributes: investment and circulation. At present, countries around the world generally recognize only the investment side of cryptocurrencies. In 2013, the United States recognized Bitcoin as a publicly tradable digital asset. But as currencies, countries around the world generally believe that the price of cryptocurrencies are extremely volatile, and although they can be used in certain scenarios, they cannot assume the function of fiat currency. In addition, the decentralized issuance of such cryptocurrencies may affect the currency issuing power of the central governments.

Central Bank Digital Currencies and Cryptocurrencies go Backwards

In terms of functionality and attributes, CBDC and cryptocurrencies are not dissimilar. Central bank digital currencies will not replace Bitcoin and other cryptocurrencies. Currently, almost all Bitcoin is held for investment purposes, not for payment purposes. Over the past decade or so, Bitcoin has grown by an average of more than 200% per year. Bitcoin's average price volatility has also gradually declined from an average of 400% per year at the time of its release. We believe that Bitcoin may become an inflation-resistant asset similar to gold in the near future.

Author: Gate.io Researcher: Edward. H
* This article represents only the views of the researcher and does not constitute any investment suggestions.
* Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.

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