-What is Central Bank Digital Currency (CBDC)?

As the name implies, the Central Bank Digital Currency (CBDC) is a virtual currency "issued" by the central bank, which uses blockchain technology. The CBDC is essentially different from the private virtual currency (cryptocurrency). The essence of virtual currency is decentralized and fully democratic currency, although most virtual currencies and tokens cannot be regarded as "currency" and have become assets for speculation and investment. Cryptocurrency is theoretically not subject to central jurisdiction, while the CBDC is completely the opposite, a currency led and regulated by the central government. Technically, although both rely on blockchain, the meaning is completely different. The CBDC is still a column in the central bank's balance sheet, one of the many forms of currency we use (cash, short-term borrowing, etc.). The central bank can use its package of strategies, such as raising interest rates, to similarly dispatch and adjust the liquidity and total amount of the CBDC in the market. Ordinary virtual currencies are not dispatched and adjusted by a central agency to adjust the supply and demand of currency. Whether it is PoW or PoS cryptocurrency, its supply and demand is theoretically determined by the market "system", which depends on the specific algorithms and rules of the private company that issues the currency. Cryptocurrency is generated through "mining". Central bank digital currency is generated through the expansion of the central bank's balance sheet, which is what we commonly call "printing money". Of course, you don't need to be so disgusted with "printing money", because "printing money" is not necessarily a bad thing. Although excessive money issuance will indeed bring about a lot of inflation, slight inflation is necessary for the economy to rise. You can think about a continuously expanding economy. The amount of money it needs must increase, otherwise an expanding economy will not have enough money.

Many cryptocurrencies claim that they are different from sovereign currencies in that virtual currencies will not be issued, so there will be no "inflation is fiercer than a tiger". In theory, the supply and demand of currency are equalized through algorithms, and there is supply only when there is demand. Take the previously collapsed large stablecoin TerraUSD as an example. This virtual currency is in the form of a dual currency, and is ultimately tied to the US dollar. If a user wants a TerraUSD (theoretically, it has a 1:1 relationship with the US dollar, that is, it is worth 1 US dollar), the user needs to "convert" his US dollar into a LUNA token through the form of coinage, and then destroy (burn) the LUNA token in exchange for one TerraUSD. The meaning of LUNA's existence is to be a medium between Terra and the US dollar; users ultimately use Terra to buy groceries. In the process of conversion, the actual relationship between the US dollar and the two tokens is not necessarily 1:1, it may be 1:0.98, but if everyone finds a place where they can arbitrage in the middle, those people will increase (i.e., mint) or reduce (i.e., destroy) a certain coin accordingly, so that the supply and demand are balanced. This principle is very similar to the basic arbitrage trading in the economy. Although arbitrage is everywhere, there are also many people or robots in today's society who can find arbitrage opportunities. If arbitrageurs all find the same opportunity, the profits will be wiped out when everyone does the same. Therefore, in the real world, in other markets, such as the stock market, there are not many arbitrage opportunities. This is also the source of the Efficient Market Hypothesis (EMH).

The current regulatory authorities generally seldom use the word "currency" to name today's virtual currencies, because 99% of the users of these currencies do not use them to buy food, but hoard them for speculative investment. The Bank for International Settlements and most central banks call virtual currencies "cryptoassets" and do not recognize them as currencies. Currency has some functions, such as being a medium of exchange, a unit of account, and a standard for deferred payment. Some can become assets that store value, and some can become legal tender. To be a currency that people can use every day, it must meet certain conditions. Currency needs to consider a series of credit risks, two of which are very important, default risk and liquidity risk. Default risk refers to the risk of default by the borrower or the issuing institution. For the major countries in the world today, this risk is basically zero. Imagine the situation where the People's Bank of China cannot issue RMB. However, most virtual currencies are controlled and minted by a private company. If the private company is hacked or runs away with the money, the default risk seems to be infinite. Of course, the essence of cryptocurrency is that it is unregulated, because it is minted by users themselves, but when a computer transfers money, it cannot guarantee that 100% of the money will be received. Therefore, if the risk of receipt is not zero, it is difficult for a virtual currency to be widely used as a currency.

After cryptocurrencies became a phenomenon, regulators and central banks have greatly increased their research investment. Long before cryptocurrencies became widely known to the public, many central banks and central governments had already begun research and various small projects to test the waters using cryptographic technology or blockchain technology. In 2016, Singapore, in cooperation with commercial institutions, began to test a settlement and clearing project Ubin through Distributed Ledger Technology (DLT) to tokenize the Singapore dollar. By 2020-2021, the project has entered the fifth and final stage. The Ubin project was implemented in the first phase in 2016 as a pilot tokenized Singapore dollar. By the fifth phase, a broader, small-scale technology ecosystem involving settlement and clearing of multiple currencies has been established.

The birth of central bank digital currency is a process in which the central bank cautiously pilots the use of blockchain technology. To date, most major economies in the world have not actually launched central bank digital currency because the uncertainty it brings to traditional finance and traditional currency regulation is still under study.

- The principle behind the central bank's digital currency -

The central bank issues digital currency directly to users, without going through a commercial bank in the middle. Ordinary cryptocurrencies are "mined" by miners, and then proof of work or holdings is used to verify the stability of information on each node. Similar to ordinary cryptocurrencies, the central bank's digital currency is used between two nodes, the central bank and the user, and information is verified through blockchain. In terms of usage, users may not feel the difference, because they all open an app, show a code to the merchant, and then the code is verified by the merchant. Using Alipay/WeChat wallets to scan the code to pay, or using a digital RMB wallet to scan the "QR code" to pay, or using a cryptocurrency wallet to scan the code to pay, the effect seems to be similar. However, on the back end and the central bank account side, these payment methods are very different.

Ordinary Alipay wallets and WeChat wallets do not have the right to mint currency. They are just a platform for us to place our cash. These platforms are called payment service providers (PSP). There are Alipay and WeChat in China, and PayPal, ApplePay and the like abroad. The money is not directly sent to our users' accounts by the central bank, but transferred from commercial banks. The central bank "prints money" not by turning on the printing press in the central bank to start printing paper money directly, but through open market operations, minting new money and issuing bonds, and then releasing liquidity through commercial banks. In simple terms, it is to put money into commercial banks such as Bank of China and Industrial and Commercial Bank of China for distribution. So our ordinary legal currency has three nodes: central bank, commercial bank/financial institution, and user. Why do we do this? All central banks in the world use this operation, which involves many complex financial theories and monetary theories. It is more effective to regulate liquidity through commercial banks, and in this process, cash will be affected by the deposit multiplier (money multiplier), because commercial banks will issue most of the money as loans, so the effect of the original money can be multiplied several times. The most important reason is that the central bank does not have enough manpower, material resources and computing power to manage its own books. If the central bank directly connects with ordinary users, then every deposit and withdrawal of ordinary users must be reflected and confirmed on the central bank's books, and the central bank may have to increase computing power and manpower countless times to handle these details. Over the past century, the operation of currency has been highly developed and subtle, and it cannot be cracked overnight or with a cryptocurrency.

Now most mainland users may choose to transfer part of the money from commercial banks to PSPs for easy use. The money circulates to the fourth node, which is these PSPs. However, most of the money still flows in three nodes, namely the central bank, commercial banks, and users.

When a user pays with WeChat or Alipay, how does the merchant know that the money is from the user/how does the merchant know that the money has been received? All WeChat and Alipay payments, no matter how fast they seem to be, seem to be real-time, but each transaction has a delay of a few tenths of a second, because our PSP needs to know the application programming interface (API) of our wallet through its technical channels to find the information of our wallet and then quickly confirm it. Sometimes if we pay from Alipay and choose "pay from bank card", the PSP needs to go to the bank API to confirm that the wallet does have so much money to use. The work behind this may only take a few tenths of a second because of today's technology, so it feels very real to the user, but each transaction behind it is strictly processed data. Currency transactions are massive data every second and every day. Only in this way can we have information to trace back to each transaction if there is an error, such as a user paying but the merchant did not receive the money, to confirm at which link the money was lost or stolen.

The principle of information confirmation in ordinary cryptocurrencies seems to be very similar to this traditional financial fast payment system (FPS), which is also confirmed between computer nodes, but its source is not a certain bank or a certain central bank, but the needs of users; and because of the irreversibility of blockchain, transactions are anonymous. Transactions are anonymous, so money laundering and crimes will also be anonymous. In pure theory, the central bank's digital currency directly sends money to users, so every transaction of users using this digital currency will be recorded in the central bank's account. As mentioned before, it will be a great challenge for the central bank to directly handle such a large amount of data. Therefore, the current pilot retail digital currency by the central bank of major countries is basically still through the three-point confirmation model of traditional financial institutions. The Ubin project of the Singapore government mentioned earlier is a collaboration with commercial banks and pilot merchants, so it has not yet been expanded to retail users. The Bank for International Settlements and the Swiss National Bank, some commercial banks and other international central banks have previously tested two projects for digital Swiss francs, Project Helvetia and Project Jura, which are also launched between pilot institutions and central banks. The Helvetia project is piloting wholesale central bank digital currency (wCBDC) with local exchanges and commercial banks, while the Jura project is piloting the possibility of cross-border wCBDC transactions with the Bank of France and the Bank of France.

- Global use of central bank digital currencies -

At present, only nine sovereign countries in the world have officially and comprehensively issued central bank digital currencies, namely Nigeria, the Bahamas, and seven countries in the Eastern Caribbean (Eastern Caribbean Currency Union), none of which are major countries. However, central bank digital currencies are the focus of pilot projects and research by several major countries. China's development of retail digital RMB is actually worthy of attention. As of October last year, the digital RMB pilot of the People's Bank of China has settled 62 billion yuan in payments, and 140 million people in the country have opened digital currency accounts. The author is one of them and has his own digital RMB wallet through the Bank of China. In China, the digital people's currency is M0 without interest. The People's Bank of China attaches great importance to the central bank's digital currency, and it is also the only major country that has truly implemented the pilot central bank digital currency project.

Most of the other important countries are still in the "talking" stage, that is, the research stage, and have not piloted CBDC as an actual project. Among them, the European Union has conducted in-depth research on CBDC, and new research reports can often be seen in the European Central Bank. India has also stated many times in public that it will release the e-rupee this year, although it is still just talking and not taking action. In addition, Russia and Brazil are also studying. Recently, Iran also proposed to start trying CBDC. The most noteworthy is actually the United States, because the US Central Bank is conservative about CBDC as a whole. If the United States wants to test the waters of CBDC, it must first get the green light from Congress, and Congress does not innovate in the name of innovation. Research continues, and there are still many uncertainties about the actual outcome.

Why is it easier said than done? Of course, it is because of the complexity of the global and domestic financial systems. For parliamentary countries, there are also policies that need to pass various parliaments and various party competitions. Central bank digital currency can be technically safer than other forms of ordinary legal currency, but people's consumption habits, terminal consumption forms (mobile phone apps), whether to increase taxes through central bank digital currency, whether and how to regulate digital currency through interest rates, etc., are all problems. The United States has always been at the forefront of financial innovation, but it has also made mistakes repeatedly. Every financial crisis is also the product of excessive "innovation" by smart people. Therefore, the current United States is relatively conservative in regulation. Congress continues to hold hearings with the leaders of major cryptocurrency companies, and there is also a small team of crypto caucuses that supports cryptocurrencies, but there is still a long way to go before the day when laws are made for them.

The recent Russia-Ukraine war has further exposed the problems of the global financial system and made more people aware of how Russia, which is under layers of blockades, can break through financial blockades through cryptocurrencies. This makes people imagine that the digital ruble, which Russia has not actually tried, may give Russia a better chance to evade sanctions.

At present, China's digital RMB is still relatively conservative. In addition to considering digital RMB as cash M0, it also abides by the principle that small money is anonymous and big money is traceable. This can prevent money laundering, which is criticized by cryptocurrency, and combat financial crimes. However, this itself runs counter to the view that cryptocurrency is completely democratic and decentralized. This also essentially shows that cryptocurrency and central bank digital currency have the same technology origin but are opposite in nature.

Combined with the above, most countries' research models are still exploring the central digital currency as one of the multiple forms of currency circulation to infer what impact will be brought if various percentages of digital currency are added. At present, mainstream countries have no plans to "digitalize" all existing currencies.

- Difficulties of Cryptocurrency -

Cryptocurrency has experienced a lot since its development, from Bitcoin at the beginning to various hard forks and soft forks after Bitcoin, and then the rise of Ethereum and the Ethereum ecosystem, which pushed the cryptocurrency market into today's prosperous scene. Cryptocurrency also has its own trilemma, which is the impossible triangle of decentralization, security, and higher performance (lower transaction costs) in the process of cryptocurrency development. In the development of cryptocurrency, if you want computers to perform node calculations, you have to bear more electricity costs (such as PoW currency). Although the triangle of the trilemma can only defend two corners, the cryptocurrency community is very innovative and has made great efforts in this triangle on a daily basis for many years. New or upgraded currencies are often safer, lower costs, and can better realize the concept of decentralization.

But private cryptocurrencies also have many criticisms. Some PoW currencies consume a lot of energy, and many currencies do not trade faster than FPS. For example, Bitcoin can trade 7 times per second, while Visa can trade 24,000 times per second. The fastest cryptocurrency Ripple trades 1,500 times per second. PoS currencies do have much faster transaction speeds than PoW currencies, and many soft and hard forked currencies have also greatly improved their transaction performance, but compared to traditional FinTech companies, they do not seem to have an advantage in terms of speed performance.

In addition, the cryptocurrency market has been proven to be very unequal from many aspects. The booming cryptocurrency market has only happened in recent years, so there is no in-depth theory or model for the market in economics. In order to prove the inequality of the cryptocurrency market, scholars have adopted some traditional economic theories and applied cryptocurrency data to obtain proof. The Gini coefficient is widely used. The Gini coefficient was originally used to measure income inequality between countries, generally measured by GDP. The coefficient is distributed between 0-1, and the closer it is to 1, the more unequal the country's income is. World Bank data shows that the Gini coefficient of the United States in 2018 was 0.41, which is in the category of not very equal. Norway is relatively equal, with a Gini of 0.276 in 2018. Zambia's Gini coefficient in 2015 was 0.571. Basically, very few countries have data in the range of 0.7-0.9, and such countries are extremely unequal.

Researchers used the data on Bitcoin wallet distribution on http://bitinfocharts.com and fitted it to the Lorenz curve of the Gini coefficient. The data obtained was generally above 0.9. I also used this data to simulate and obtained a data of 0.9. Based on this, Bitcoin ownership is very unequal. Most people hold very little wealth, while the top wallets have divided up the vast majority of wealth.

But these are not the reasons why the central bank wants to develop digital currency. With the development of cryptocurrency, there are more and more cases of money laundering, money-raising and absconding by some cryptocurrency, and hackers hacking into large sums of money. This makes the central bank very cautious and wonders whether it will generate systemic risks as the market develops. After the 2008 financial crisis, regulators realized that systemic risks are as important as risks between financial institutions, and the financial system may collapse directly. The Basel Association has added macro-prudential regulations on the basis of micro-prudential regulations. The 2008 financial crisis made regulators realize that ordinary investors may not be able to identify projects, even if the information is relatively complete, and the low valuation of the project will make these investors' wallets flatter. These ordinary investors often blame the government for not doing a good job of supervision. There are many cases in the cryptocurrency circle where investors have lost all their money due to hacker intrusions, project collapses, or platforms privately banning the wallets of some users, or investment projects do not match the accounts.

The previous UST crash can be described as the "Southeast Asian financial crisis" moment in the cryptocurrency circle. Unlike the Southeast Asian crisis, the UST crash did not cause a systemic collapse of the financial system. The short sellers found the right opportunity to make a fortune, but it did not have a big impact on most people in the world or in some regions. UST was also decoupled before the collapse in 2022. In addition to UST, scholars have repeatedly pointed out that Tether, the leader of stablecoins, has inconsistent accounts. In 2017, Newsbtc pointed out that the stablecoin big brother Tether had a current debt of $42,313,582.47 on its books and only $41,371,231.42 in current assets, causing investors to lose about $1 million. In April 2022, Neutrino, one of the top ten stablecoins, released by Chengdu Lian'an, was pointed out by Blockworks that the correlation between its coin price and the US dollar reached 20%. For a 1:1 US dollar stablecoin, a 20% fluctuation is very large. After the collapse of UST, many stablecoins also suffered varying degrees of selling. Imagine that you go to buy groceries and suddenly the cash in your hand depreciates to 80% of its previous value.

Compared with the trillion-dollar assets in the traditional financial market, the total market value of the cryptocurrency market is just the tip of the iceberg. However, its rapid growth has made regulators very alert. Governments in various countries have their own tricks. Some have directly driven cryptocurrencies out of the country and piloted central bank digital currencies themselves. Some have frequently asked private currency leaders to attend hearings. The regulatory bills of various countries on cryptocurrencies are getting more advanced, and they are also vigorously piloting more stable and secure central bank digital currencies to squeeze the market for cryptocurrency as currency.

- Future CBDC and Monetary Reform -

Currently, there are only two countries that use decentralized currency (Bitcoin) at the legal level. One is El Salvador, which does not use the US dollar as its own currency, and the other is the Central African Republic, which recently joined the game.

For central banks of various countries, especially the central banks of major countries, the digital reform of currency is of vital importance. For the RMB, there is also its internationalization path. Digitalization is because it is a necessity of the times. CBDC is one of them, not all. Digitalization has many meanings, making transactions more convenient and faster. Cross-currency transactions and transfers must improve interoperability while ensuring legality and security. At present, the interface of cross-border transactions of currencies of various countries is not very smooth. There are many political factors in the middle, but there are also technical reasons and some transaction barriers that can be improved. Currency is a manifestation of national exchanges, such as war, diplomacy, trade and cooperation. On the one hand, improving the adaptability of the currency side is necessary to strengthen international cooperation. On the other hand, it reflects the competition of currencies of various countries in terms of technology in the strategic sense that countries/regions try to provide their own currencies, and it is also a manifestation of countries competing for cultural, military and diplomatic influence.

At the same time, after many crises, the central bank's basket of measures to adjust the economy is becoming less and less. The current inflation in the eurozone and the dollar zone can be said to be hated by the people. But even if the central bank is under pressure from behind, the central bank presidents of the United States and Europe have been criticized by netizens and economists. As an auxiliary political institution, it is difficult for the central bank to structurally revolutionize the nature of currency. Some stablecoin plans (such as the collapsed Terra 1.0) proposed that their projects can prevent inflation that is more ferocious than a tiger because the money supply is constant, but Economics 101 tells us that a vertical supply line is difficult to adapt to a changing demand line.

CBDC and currency reform are the priorities of central banks, so I am also happy that I am unlikely to lose my job, but currency reform is not about technology, but about the convenience of serving the people. Technology will not make inflation disappear.

At present, CBDC projects are basically in the stage of theoretical testing on a global scale, and are still in the stage of Proof of Concept or Prototype in terms of projects, so China's testing of (retail) digital RMB is already very avant-garde among countries. The author was fortunate to go to a small CBDC seminar with the Bank for International Settlements in Zurich, and saw some CBDC projects tested by different central banks for domestic and cross-border settlements. In general, the birth of CBDC must make domestic currency and cross-border payments more convenient, and it is also a means for international organizations to improve "financial inclusivity". However, when asked about how much real funds were used to test the CBDC project (the test project does not necessarily have to use real funds, virtual funds can be used to run a feeling), how many days the project ran, and how it plans to be used in actual combat in the next stage, the central bank leaders basically said they didn't know. When asked whether CBDC will be faster and cheaper than traditional finance, the answer is not completely affirmative. In theory, CBDC uses blockchain technology to complete cross-border multi-currency settlements in real time, which is currently impossible in the real world (the real world takes 24 hours). Theory is theory, and in the real world there are laws and regulations that will extend the payment time. For example, the cross-border payment "mBridge" project jointly tested by the Digital Research Institute of the People's Bank of China, the Bank of Thailand, Dubai, and the Hong Kong Monetary Authority, the currencies of the four regions can theoretically be settled in real time through CBDC. If this plan can be put into practice, it will greatly increase the efficiency of trade between the four regions. However, the problem is also obvious. Who will listen to the laws and regulations, who will review them, and who will provide the flow pool (funds) for transactions in the four regions? In response to this series of problems, CBDC has a long way to go, whether for business or retail.

So why should countries research and test CBDC?

It is understandable that large countries/regions such as Europe, the United States and China are testing CBDC, because some users in these countries have low bank usage rates, while some have high smartphone usage rates. Moreover, such large countries and influential currencies need to spend money on testing to increase their influence and strengthen international cooperation. It is also understandable for some small financial centers such as Switzerland, Dubai and Singapore, because trade and cross-border finance are very important to their own countries, and they need to test ways that may make transactions faster. Japan, another important currency country, is also understandable. It is also understandable that international organizations promote the vigorous research and development of CBDC, because international organizations need to promote the "financial inclusion" of international financial entities, and countries test CBDC in the hope of entering this "club" without being excluded.

However, CBDC research and testing also cost money. For the government, currency reform must be based on "serving the people". Have you created this new way of transaction to make it easier for people to spend money? Is trade more convenient? Can you really join the international financial inclusion club? The author also feels that some central banks are a bit too "fashionable" in joining the reform and experiment of CBDC.

The user end of using CBDC basically corresponds to the development of smartphones. The display form of CBDC on the terminal is currently in the form of a "QR code". For countries that do not even have many people using smartphones, it is a bit of a waste of funds to force them to do CBDC research. Many years ago, I worked on a case of an African financial company being acquired in an investment bank. The company allowed people in some African countries to use simple and convenient "text message finance". Some people in Africa may not have a smartphone penetration rate, but everyone has a PHS/Nokia. If you want to transfer money, just send a text message. I think this financial innovation is truly serving the people, and it is smart to use local materials to popularize more finance. Therefore, for some countries that are obviously financially poor, I don’t think that studying CBDC will solve their messy monetary policy problems. At the same time, CBDC will not solve geopolitical problems or allow some countries to join the international financial club. At the Zurich conference, I listened to major central banks and international organizations emphasizing the improvement of "financial inclusion". I have a question, do Russia and Iran count? Of course, I didn’t ask on the spot. When I saw that Iran had also joined the CBDC research, I was a little hesitant. Researching CBDC will not solve the country's annual inflation of 30%, nor will it make it a financial power, and it will not allow other countries to buy oil. Even though Iran has a high penetration rate of electronic communications and Russia has used virtual currency to circumvent sanctions, these are not the point. The point is, has the development of CBDC solved the essential problem? Has it served the people? Is CBDC your new card to join the world club? Can buying an Hermès allow you to join the ladies club? Have you found the key to the problem?

#whycrypto