Understanding government cryptocurrencies

The topic of Cryptocurrencies is in the spotlight again, with discussions about NFTs and Reddit millionaires in recent months. People are becoming increasingly interested in this little understood field and are looking at crypto as a viable investment strategy. With the most famous Cryptocurrency- Bitcoin recently becoming a 1 Trillion dollar asset class, even some governments are taking a second look at Digital Currencies, as both an opportunity and a threat.

Governments of many countries are considering, or are in the process of developing their own ‘Central Bank Digital Currencies’ or CBDCs. These are proposed to be akin to an official ‘Government Cryptocurrency’.

What are CBDCs?

CBDCs are essentially Digital Currencies issued by Central Banks. They are a blend of Cryptocurrency and normal Fiat Currency. Until last year, only 2 countries were serious about Cryptocurrency, namely China and Sweden. Since then, many more have joined, with most Central Banks, including the likes of UK and the EU, either researching or piloting some form of CBDC. Though Digital Currencies are in not on the horizon just yet, owing to complications of money laundering, terror financing and user privacy among many others, the technological foundations are solid and getting better every day.

The appropriate technology that will carry that digital currency is still about two to four years away. this further is so significant that the bank of international settlements predicts that within three years twenty percent of the world’s population will be living somewhere that uses a CBDC.

Why are Governments enthusiastic about CBDCs?

The enthusiasm of states is understandable. Firstly, digital currency is far easier to track which means that they’ll be better equipped to tackle tax evasion, money laundering and terrorist financing. A digital currency will also provide states with near total knowledge of their economy. This information could be used to form more effective economic policy with more growth and smaller recessions, but perhaps the biggest reason that states are keen on CBDCs is that CBDCs protect their monetary sovereignty.

Digital Currencies like Bitcoin and DM threaten states monetary sovereignty. Let’s use dm as an example. DM (originally called libra) is Facebook’s proposed digital currency. The worry for states, especially states with unstable economies is that citizens might start using DM as their default currency instead of their state’s currency, which would limit a country’s ability to affect monetary policy. If people aren’t using the state’s official currency, then increasing supply, manipulating interest rates and all of the standard economic tools become far less effective.

Official state CBDCs have some advantages over DM and other cryptos and states are hoping that CBDCs can dissuade citizens from abandoning their national currencies and turn to the ‘digital dollar’ instead, which leads us on to the next question: Why would citizens agree to CBDCs?

In addition to creating better economic conditions for the whole country, they’re also more hygienic than banknotes and it’s plausible that states might legally require the digital currency; entirely phasing out the physical variant. But perhaps the biggest advantage to individuals is that CBDCs will be cheaper and more convenient.

At the moment, there is an entire infrastructure of third-party private companies that facilitate mobile payment. Think of PayTm or Google Pay in the UK and India or WeChat Pay in China. One of the functions of Commercial banks is to act as middlemen between the Central Bank and the individual. Transaction fees for this, for an average person is 350 dollars a year in the US. But if the state decides to facilitate a direct connection between the Central Bank and individuals instead, then this should in theory mean lower transaction costs, making things cheaper and easier for individuals and businesses.

Limitations of CBDCs

For all its benefits however, CBDCs aren’t all rosy. There are some possible downsides, chief amongst which is giving the state total information about their citizens economic activity. This could be a slippery slope into a totalitarianism. Imagine instant e-fines for bad behaviour or limits on what kind of things you can buy.

CBDCs might also have some possible disadvantages for states. Firstly, states with less stable currencies still risk their monetary sovereignty being undermined by large state CBDCs. Taking Turkey as an example, President Erdogan’s aversion to high interest rates and habitual sacking of central government bankers, the Lira is in crisis. In response, Turkish citizens have now moved towards the US Dollar and now keep an increasing proportion of their savings in Dollars. One can imagine that, if a digital dollar was easily available, Turkish citizens wouldn’t just save in dollars, they’d use digital dollars for all of their transactions and the dollar could become Turkey’s default currency. Essentially, an easily accessible foreign digital currency would be more likely to replace an unstable state currency, thereby further undermining state’s monetary sovereignty.

The final possible downside to CBDCs is the impact they’d have on traditional banks. Essentially, commercial banks accept lots of money on the assumption that everyone wouldn’t need their money at once, lending some of that money out to other people. This is a process known as fractional reserve banking, where only a fraction of a bank’s deposits are backed by actual cash available for withdrawal, with the rest being loaned out. Banks make money on the interest from those loans. This system has fuelled the entire economy for centuries, but CBDCs might remove the need for bank deposits upon which fractional reserve banking relies. Citizens might just use their state-issued digital wallets and store all of their money in there which could undermine the entire system of money lending as we know it.

It must be stated that everything related to cryptocurrency is still shrouded in mystery. No one knows what all of this will mean. No one knows what role Central Banks might play in lending CBDCs or whether venture capital could replace bank lending or whether banks will necessarily collapse. But it’s worth noting that CBDCs have at least the potential to completely upset the financial system. Before cryptocurrencies are introduced to the mainstream, decisionmakers must face these tough questions.