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Cryptocurrencies versus Central Bank Digital Currencies



Central Bank Digital Currencies (CBDCs) and cryptocurrencies both share the same roots in the 1990s when the concept of digital currencies first came to light as creative people looked for ways in which technology and money could converge. But that is where the commonalities end. CBDCs are specifically designed to increase the centralized control of the government while Bitcoin was borne out of the 2008 financial crisis and the loss of trust in centralized financial institutions.


Let's kick off with the CBDCs. CBDCs are digital tokens issued by a central bank and they are pegged to the value of the country's traditional currency - also known as fiat currency. The reasons given by governments to introduce CBDCs are common across all countries. They say that want to increase financial inclusion, make it easier and safer to transact, they want to enhance the privacy of the consumer, and they want to reduce the costs of transacting.


In many developing economies, people do not have access to the financial services sector. The top three reasons for this are not having enough money, high or unpredictable fees, and lack of trust in the banks. The main goal of CBDCs is to provide businesses and consumers with greater access to financial products.


There are two types of CBDCs:


1) Wholesale

These are primarily used by financial institutions. The central bank provides an institution with an account to deposit funds or use to settle interbank transfers.


2) Retail

These are used by consumers and businesses. There are two types of retail CBDCs. The first is a token-based CBDC that is accessible through public/private keys which allow users to transact anonymously. The second is an account-based CBDC that requires digital identification to access the account.


The first official CBDC was launched in the Bahamas and is known as the Sand Dollar which is pegged to the Bahamian dollar which in turn is pegged to the United States Dollar. There are two tiers to the wallet. Tier 1 can hold a maximum of 500 Sand Dollars and there is a $1,500 transaction limit. It cannot be linked to a bank account and no government ID is required to open the wallet. Tier 2 has an $8,000 holding limit and monthly transactions are capped at $10,000. A government ID is required at enrollment and it can be linked to a bank account.


The reasons provided on the Sand Dollar website as to why people should use it were:


1) it is much safer than cash. The wallet is a software wallet which means it is not stolen in the event your smartphone is stolen.

2) it provides an excellent record of income and spending, which can be used as supporting data for loan applications.

3) it can be accessed flexibly with either a mobile phone application or using a physical card that can be used to access the digital wallet.

4) it presents zero transaction fees for individuals.


So what is the difference between CBDCs and cryptocurrencies? You could argue that cryptos were created as an alternative to the fragile and corrupt international banking system that was almost brought to its knees in 2008. A secret message in the first token of Bitcoin refers to bank bailouts- Santoshi expressing his unease with living in a world that could be brought to its knees by corrupt bankers. CBDCs were then developed as a response to the widespread appeal of cryptos and the fear of central banks that they may lose their monopolistic control over money.


Very simply, CBDCs are centralized currencies that require permission to be used while cryptocurrencies are non-centralized currencies that tend to not require any permission to be used.


This point of decentralization is an important differentiation between the two types of currencies. The blockchain is a decentralized ledger in the sense it is not controlled by one party. It is controlled by a large number of institutions and individuals in different locations and is completely unrelated. Don't be fooled by central banks who say they are using the blockchain and therefore CBDCs are awesome. This does not mean they will be relinquishing control - the fact that transactions are stored on a blockchain does not always mean they are decentralized. The Bitcoin protocol is decentralized and uses the blockchain, but these two things are not mutually exclusive.


You also need to understand the difference between coins and tokens. Coins are given as rewards to the computers that process the transactions for a cryptocurrency's blockchain. These coins are also used to pay for the transaction fees on that blockchain. So BTC is given as a reward for those that process transactions on the Bitcoin blockchain. These miners also earn the transaction fees paid in BTC. A token on the other hand is a customizable asset that exists on a cryptocurrency's blockchain. Tokens can be used for all kinds of things. For example, nonfungible tokens are used to verify ownership of a unique piece of art. There are also tokens known as stablecoins that mirror fiat currencies - the most common being the US dollar. Creators of these tokens can give themselves complete control over the transfer of ownership of those tokens and the supply of these tokens. This was the case with centralized stablecoins which are essentially controlled by the companies that issued them. This centralized nature of some stablecoins is the reason why decentralized stablecoins have become so popular. Decentralized stablecoins are pitched as crypto's holy grail due to Bitcoin's massive price volatility. Stablecoins now account for $130 billion of crypto's total market capitalization. The vast majority of the stablecoin marketing is made up of centralized tokens issued on top of blockchains like Ethereum, Tron, BNB Chain, and Solana, and they include backdoors that enable the issuers to do things like freeze funds and blacklist addresses. In addition, they could be regulated out of existence with the strike of a pen.


This concept of a censorship-resistant stablecoin has been tried many times in the crypto space. Up until this point, the most successful decentralized stablecoin has been DAI with a market cap of $6 billion which is more than 8 times bigger than its closest competitor. It is heavily integrated into Ethereum's Defi ecosystem but there is a twist. DAI has foregone its original promise of decentralization in order to reach its current level of adoption. The majority of DAI is currently backed by USDC and other similarly centralized assets - in other words, it is inheriting the centralization found in the assets that it is using to back its stablecoin.


We now need to understand the economics of currencies. Under the current system, central banks are mandated with the task of stimulating growth while keeping inflation under control. The lever they use to do this is through raising and lowering interest rates. When rates are low, money is cheap and saving is less attractive - people then to and spend and this creates economic growth, but this also increases inflation because there is more money chasing the same goods and services. When interest rates are high, it becomes expensive to borrow and more attractive to save. People save more and spend less and this lowers economic growth, and it decreases inflation. It is far easier to inject money into the system than to drain money out of the system. This creates a problem with inflation which we are now seeing more signs of. Before inflation recently raised its ugly head, interest rates were low and both companies and individuals made the most of these low rates to borrow at record levels. Now that interest rates are going up, this is putting pressure on these entities to pay these debts back. Governments are also running record levels of debt and cracks are starting to show in some countries as they struggle to service this debt.


So, this is the problem that many central banks have. Inflation is rising, and central banks need to aggressively raise interest rates but they are concerned about how that will affect companies and consumers.


For central banks, CBDCs are an attractive solution because it will be as easy for central banks to issue money as it will be to destroy it. Let's go through the list of things the central bank love about CBDCs


1) they will be able to freeze CBDC holdings

2) they will be able to limit CBDC holdings

3) they will be able to set expiry dates on them

4) they will be able to set time limits on them - when they can and cannot be spent

5) they can set limits on spending- for example, x percent on food and y percent on travel

6) they can decide what can be bought with them

7) they will be able to automatically tax CBDC transactions

8) they will be able to customize CBDC parameters for certain people

9) they will be able to implement negative interest rates on CBDCs - in other words, they can delete CBDC balances unless they are spent before a certain time.


This is an enormous centralization of control. Some central banks are using CBDCs as a way to fight against the continued adoption of crypto, because those are currencies over which they have limited control and pose a real risk to their monopolistic control over money.


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