Differences and Connections Between Cryptocurrencies and CBDC

Introduction

Since the 21st century, the economy has become increasingly digitized, with ongoing innovations in currencies and their systems. The digitization of the economy is altering the way people use payment methods. Currency has evolved to date and is trending towards the form of Central Bank Digital Currency (CBDC). In recent years, cryptocurrencies and central bank digital currencies have drawn worldwide attention. Lots of large technology companies have been gradually involved in the cryptocurrency field, and cryptocurrencies have been growing in terms of quantity, market value, and user base. As a result, central banks worldwide hope to integrate cryptocurrencies’ underlying technologies into their financial systems.

Cryptocurrencies are subject to significant volatility and uncertainty. In May 2022, the failure of various cryptocurrencies sparked discussions, including the collapse of TerraUSD, the third-largest stablecoin. In November of the same year, FTX, a centralized cryptocurrency exchange, closed down. Silvergate Bank, Signature Bank, and Silicon Valley Bank, which served cryptocurrency service providers, filed for bankruptcy in the following months. Although these developments have little impact on traditional financial markets, they did lead to a massive sell-off of various cryptocurrencies, resulting in a significant decrease in the overall market capitalization of the cryptocurrency industry. This turmoil led to stagnation in the growth of the stablecoin market and almost eliminated unsupported stablecoins.

The uncertainty in the digital currency market poses a threat to financial stability. To mitigate the risks to their domestic financial systems, many countries have stepped up the research and development of CBDCs. In July 2023, the Bank for International Settlements (BIS) released a survey report on central bank digital currencies (CBDCs) and cryptocurrencies, stating that the proportion of central banks engaged in CBDC work had further raised to 93%. In this article, the author analyzes cryptocurrencies and CBDCs at length, elucidating the differences and connections between cryptocurrency and CBDC.

What’s CBDC?

CBDC (Central Bank Digital Currency) is a digital payment tool denominated in the national unit of account. As a digital currency essentially endorsed by the national government, it is directly issued and managed by the central bank. Unlike traditional cashless payment instruments such as credit transfers and electronic currencies, CBDC is entirely owned by the state and represents a bond to the central bank, rather than a liability to private financial institutions, with no intermediary banks or financial institutions between citizens and the central bank.

CBDC can be divided into two main categories: retail CBDC and wholesale CBDC. The former is used for daily transactions by households and businesses, while the latter is primarily used for transactions between banks, central banks, and other financial institutions. Therefore, wholesale CBDC serves a function similar to reserves or settlement balances held by central banks.

Physical cash banknotes are tangible forms of legal tender issued by the central bank, representing a form of liability to the central bank directly used by consumers. Although they can be used for “digital” transactions, they are not “digital currencies”. Although legal tender is regulated by the central bank, it is not operated directly by the central bank, with other banks and financial institutions acting as intermediaries between the central bank and citizens for all purposes. Commercial banks need to generate (e.g., lending activities) or account for the necessary legal tender required for citizens’ daily lives and report it to the central bank. Therefore, commercial banks are responsible for maintaining the ledger for these transactions, whether online or offline. In contrast, CBDC is a digital currency supported by national authorities, enjoying the legal tender status of physical cash banknotes but existing in digital form. It is fully controlled by the central bank, completely excluding commercial banks.

Main Forms of Currency

Cryptocurrencies (Crypto) are not issued or regulated by central banks, but rather operate on decentralized systems, using crypto technology to record transactions and issue new units.

Cryptocurrencies run on distributed public ledgers called blockchains, where users can also purchase currencies from brokers and then store and spend them using crypto wallets. The process of transferring and transmitting cryptocurrency data between wallets and public ledgers involves advanced coding. Users of cryptocurrencies do not possess any tangible assets but rather hold a key that allows them to transfer records or units of measure from one person to another without a trusted third party. Bitcoin is the first cryptocurrency in history. It was founded in 2009, and now it has grown into more of a speculative tool.

Over centuries, currency has taken many different forms, from commodities initially used for exchange to financial currency, further evolving into paper money, and subsequently developing into forms such as debit cards and credit cards. The table below provides a comparison of the main forms of currency:

Differences Between Cryptocurrencies and CBDCs

In terms of centralization, cryptocurrencies are issued by private entities and are not accepted as legal tender. In contrast, CBDCs are fully centralized with the backing of national credit, granting governments sovereignty over their use in the economy and digital currency realm.

From the perspective of anonymity, the identity of CBDC users will be associated with existing bank accounts and a similar amount of personal information, whereas cryptocurrency transactions are entirely anonymous, with users holding keys to ensure security.

Regarding usage, CBDCs are limited to payments and trading with other currencies, while cryptocurrencies can be used for speculation as well as payments, with cryptocurrencies like Bitcoin primarily serving as investment tools.

Connections Between Cryptocurrencies and CBDCs

Bitcoin is a mainstream cryptocurrency, and blockchain technology originates from Bitcoin. Central banks around the world have generally taken a cautious or exclusionary approach toward cryptocurrencies represented by Bitcoin. Blockchain technology can still be effectively utilized in various aspects of CBDC development and management even if it conflicts with the decentralized nature of blockchain technology and the centralized management of central banks.

Blockchain technology can be used to assist CBDCs in securely transferring ownership and providing programmability through built-in smart contracts. It can be used for CBDC authentication, wholesale payment settlement, and cash digitization, enabling central bank digital currencies to operate distributedly without compromising centralized management.

Conclusion

The cryptocurrency market is more oriented towards asset investment. While many countries have made significant efforts in cryptocurrency regulation policies, innovations are constantly made in the technological development within the cryptocurrency industry. CBDCs leverage blockchain technology from cryptocurrencies to enhance their capabilities in crime prevention and promote inclusive finance, ensuring central banks’ control over currency in the digital age. It also takes time to establish trust in central bank digital currencies. Moreover, as central banks gradually phase out digital currencies, regulatory oversight of the cryptocurrency industry is becoming increasingly stringent.