In the last months we have heard experts, politicians and legislators talk a lot about central bank digital currencies, and how they could represent an advantage for central banks, some claim these could be a game changer for monetary policy since we could explore new ways to implement monetary policy; this being triggered by the current outlook in which we live. Central Banks have often struggled with increasing interest rates and leave the ZLB (Zero Lower Bound), but this might be about to change thanks to central bank digital currencies, also known as CBDCs. Despite all the discussion that has been taking place, there is still some confusion around this new-coined term, and we will try to point out the differences and potential similarities that CDBCs and cryptos might share.
We will start off by defining what a cryptocurrency is. A cryptocurrency according to Oxford: “a digital currency in which transactions are verified and records maintained by a decentralized system using cryptography, rather than by a centralized authority” (Oxford Languages). But this might be too sophisticated to understand, so we will simplify it a bit. Cryptocurrencies base their existence on four basic principles which are decentralization, immutability, anonymity, and scarcity. Let’s explain one of them, taking Bitcoin as an example. Bitcoin is a cryptocurrency which exploits the advantages of the blockchain to create a decentralized network in which no single human voice has power over the transactions made within the network, nor can alter them.
The term blockchain refers to a database which is distributed and shared among the nodes of the network, with all the participants. When a transaction takes place, this change is approved and recorded by all the nodes, this democratizes the writing of information and prevents fraud. The second characteristic is immutability, each and every bitcoin is unique, so are transactions. Transactions can be audited at any time and since they are being stored by all the individuals who make part of the network, we would need most of them to vote in favor of changing the common ledger. This feature makes the Bitcoin system fraud-proof. Anonymity comes from the fact that Bitcoin exchanges public keys when a transaction is performed, these keys do not include any personal information. The last point to address is scarcity, Bitcoin is a scarce currency, just as gold is, it has a limited supply and around the year 2140, no more bitcoins will be created, and Bitcoin mining will cease. Given the cryptographic characteristics of their system and blockchain, it will be technically impossible to increase its supply in the future.
On the other hand, CBDCs work in different ways as cryptocurrencies. Their architecture has not already been constructed for most of the fiat currencies, central banks have just recently started to conduct some research on the different types of approaches that could be taken. CBDC would most probably not use a blockchain framework, using Blockchain would mean they would be constrained to be decentralized which goes completely contrary to the nature of fiat currencies and the nature of a central bank. Nevertheless, immutability and anonymity are some characteristics that will be tried to be preserved. Some scholars have pointed out the privacy issues that CBDCs might give rise to, especially in authoritarian regimes, in which the storage of data could be concerning for citizens or how the management of it could represent violations to their inherent rights.