Bitcoin is truly amazing. Why can’t I use it to get a coffee or pay my taxes? Although Bitcoin is a digital currency, it may not be the best option for everyday transactions. Central bank digital currency (CBDC) is another type of digital asset that will most likely fit the objectives of this application.
While some countries have already begun to experiment with purely digital currencies, many others are currently researching the concept. But what differentiates CBDCs from other types of virtual currency? I propose that we find out.
Traditional finance’s network for transferring funds has fallen behind the rest of the world. Despite being only slightly more involved than moving bits from one point to another, money transfers can be time-consuming and costly.
Many countries are actively working on developing a new type of digital currency. The key benefits would be increased payment system efficiency and lower associated costs. CBDCs are a form of digital fiat currency constructed using a brand-new technology layer that draws inspiration from blockchain technologies.
Many countries are anticipated to move to digital currencies within the next decade. So, how do they function?
What is a central bank digital currency (CBDC)?
A central bank digital currency (CBDC) is an example of a digital fiat currency. As a result, government regulation classifies it as money.
The process of establishing a CBDC will most likely differ substantially among countries. Some solutions may use distributed ledger technology (DLT), such as blockchain, while others may use a more typical centralized database. Tokens will serve as digital fiat currency in blockchain-based systems.
CBDCs are conceptually related to cryptocurrencies such as Bitcoin, but they operate fundamentally differently. Governments issue CBDCs and accept them as legal tender.
Bitcoin and other cryptocurrencies function independently of governments and central authorities, making them universally useful. However, you will be able to utilize a CBDC to make worldwide purchases because Bitcoin has no idea of national borders.
CBDC proof-of-concepts are being considered or tested by a number of government-run financial institutions.
China has been working on a digital currency and electronic payment system known as DC/EP since 2014. The implementation of the digital yuan in several trial initiatives has already begun. The European Central Bank (ECB) produced a paper in October 2020 suggesting a digital euro and examining the benefits of such a digital currency.
Recognizing National Central Banks’ Digital Currencies
In terms of technology, a CBDC is similar to any other government-run (or possibly private-sector-approved) database. That is why a CBDC is a password-protected database; only authorized users may make purchases on the system.
This means that the database’s central authority has the ability to halt transactions, reverse them, freeze funds, and blacklist IP addresses.
Several CBDCs are likely to use independent blockchains. However, some of them may be transmitted via public blockchains. This would enable the settlement of permissioned assets on top of a permissionless underlying layer. This might provide the best of both worlds, with the permissioned layer providing the essential control for central banks and the permissionless layer giving the highest security assurances.
However, this is not the norm and is unlikely to continue. There is currently no public blockchain that possesses both the technological capability and the track record of dependability required to safely carry out such an important job.
Aside from that, it’s difficult to provide a broad picture of how a CBDC works because each country has its own strategy. All of them will very certainly adapt the technology to better fit their own needs.
Benefits of Central Bank Digital Currencies (CBDCs)
You may have heard the phrase “banking the unbanked” in relation to digital currencies. CBDCs, rather than decentralized cryptocurrencies like Bitcoin, may be better suited for this purpose. More people can engage in the financial system if every legal resident has easy access to a low-cost bank account.
Payment system modernization has the ability to boost technology as well. Despite the fact that most fiat currency is nothing more than numbers in a database, the underlying infrastructure is essentially ancient. Sending an email on a Sunday afternoon should only take a few seconds. Unfortunately, the current financial framework makes transferring funds take many days.
This was seen during the central banks’ interventions in the economy following the COVID outbreak. CBDCs have the potential to facilitate central banks’ and financial institutions’ direct implementation of monetary policy modifications. This might have a huge impact on how central banks operate.
With the assistance of a CBDC, governments and central banks may more readily monitor unlawful operations.
CBDC and Stablecoin Comparison
Doesn’t this sound suspiciously like a stablecoin to you? They both serve the same function in that they are digital token representations of fiat cash. They are, nevertheless, fundamentally separate from one another.
A private company may frequently issue stablecoins, which are essentially representations of fiat currency or other assets. They are not money in the traditional sense, but they can be exchanged for the value they represent.CBDCs, on the other hand, are a type of fiat money that the government issues.
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CBDC vs. Cryptocurrency Comparison
CBDCs differ from cryptocurrencies in a variety of respects, as previously mentioned. When a central bank issues CBDCs, the government accepts them as legal tender. In the same ways that paper currency acts as a unit of account, a means of payment, and a store of value, so too does a CBDC.
Bitcoin and other real cryptocurrencies are not the same. Governments do not issue them, and they are unconcerned about international borders. They are permissionless, trustless, and censorship-resistant. The network is also not governed by a single authority. By blacklisting your Bitcoin address, no one can block you from sending Bitcoins to any other Bitcoin address.
Which is better, then? The answer is conditional. The unique idea of Bitcoin is that Alice can send Bitcoin directly to Bob without any third parties or restrictions. However, there are a few drawbacks to think about. What happens if a large sum mysteriously disappears? But what if Alice sends her retirement money to the wrong place?
The capacity of an organization to cancel transactions and ban IP addresses is a useful tool. On the other hand, there are times when taking advantage of a decentralized network like Bitcoin makes more sense.
Digital currencies issued by a central bank are essentially electronic, similar to traditional fiat currency. Many CBDC implementations will very certainly make use of blockchain technology, making digital payments more accessible to everyone.