CBDCs, central bank digital currencies, are currently a buzzword amongst many financial institutions. CBDCs are digital tokens issued by a central bank. Like cryptocurrencies, they are pegged to the value of the country’s fiat.
Algorand blockchain recently released a whitepaper titled, “Issuing Central Bank Digital Currency Using Algorand.” Our earlier report coverage focused on key details on using Algorand for CBDCs. The article examined Algorand’s model for using CBDCs and its advantages compared to other token-issuing L1 protocols.
For this piece, we’ll take a closer look at the concept of CBDCs, types of CDBCs, issuance, and implementations. It is no longer news that digital advancement has reached banking institutions’ doorsteps. As a result, banks have no choice but to find ways to explore opportunities in the growing digital market.
Algorand’s 2022 Central Bank Digital Currency report is here. Co-authored by a team of leading economists and researchers, this new report highlights six considerations for central banks when evaluating the design & implementation of CBDCs.
Learn more 👇 https://t.co/Zvo4VwUREE
— Algorand (@Algorand) July 19, 2022
Crypto service providers offer strong competition for banks by simplifying cross-border payments, making them cost-effective. As a result, most banks are overhauling their current payment infrastructures in favor of newer and more modernized ones.
CBDCs are issued by banks that have chosen to modernize their payment systems. Although not all central banks have looked in this direction, many banks are adopting CBDCs.
There are different reasons why central banks worldwide are increasing their participation in CBDCs. First, central banks want to maintain monetary sovereignty and support the digital economy. But most significantly, these apex banks are investigating retail CBDCs to reduce the cost of cash.
The European Central Bank calculated that the entire cost of retail payment instruments to society in the EU in 2012 was around 1% of GDP (139 billion euros), with cash accounting for nearly half of this cost.
Foreign exchange operations play another huge role in the consideration of CBDCs. These operations have substantial costs for participants, which is an issue for emerging markets in particular. Furthermore, these exchanges go through a series of confirmation processes. But blockchain transactions are more direct and faster to process.
The rise of blockchain technology and its potential to enhance the financial system has made CBDCs more appealing. Blockchains such as Algorand have the perfect foundation, security, and features to offer CBDCs.
Algorand’s consensus algorithm guarantees that transactions are quick and instantly final and that the blockchain never soft forks. This makes Algorand a perfect blockchain for CBDCs. The Algorand blockchain has established a framework to move CBDCs from an experiment to real-world use.
Algorand proposes a hybrid CBDC model that ensures central banks have complete control of the CBDC and delegate tasks to institutions they deem fit. Additionally, licensed service providers (LSPs), including commercial banks, remittance companies, and other fintech firms, can simultaneously facilitate distribution and transactions. Blockchain-based retail CBDCs have huge advantages. For example, they can aid financial inclusion since their services reach more regions than traditional bank accounts.
Types of CBDCs
The central bank digital currency is a type of fiat currency issued by the apex banks of several countries. These central banks also retain full control of this digital currency since they are responsible for issuing it.
There are two main categories of CBDCs:
- Wholesale CBDC: Banks and other financial organizations are the main users of wholesale CBDCs. Banks can make payments more efficiently and automatically by using CBDCs. This feature can possibly affect international trade. Blockchain technology has the potential to speed up, simplify, and increase the reliability of transactions.
- Retail CBDC: Individuals are the main users of retail CBDCs. They use them mostly as a form of payment with full authorization from the central bank. Retail CBDCs have the potential to replace the need for physical cash.
Advantages of CBDCs
CBDCs have the potential to change and influence the financial landscape. With the world going fully digital, CBDCs offer unlimited advantages. Here are some benefits of CBDCs:
- Boost payment efficiency
- Complement existing financial instruments and services
- Expand international payment options
- Improve the reach of financial services
- Increase adoption of digital services
- Create trust in digital payment options
Digital Trends That Will Affect CBDC Adoption
According to the report, four key trends are defining the digital age, which would trigger massive adoption of the central bank digital currency, which are:
- A growing digital economy: The digital space has evolved over the last few years. Although it is difficult to pinpoint the exact size of this digital progress, there is a consensus that the digital economy has outpaced the real-world economy for the past decade. The rise of decentralized finance and other blockchain tools has aided this growth. And the trend will most likely continue for the foreseeable future.
- Asset tokenization as a new business model: Blockchain facilitates asset tokenization as a novel business model native to the digital economy. The on-chain value of tokenized assets is horizontally and vertically integrated, eliminating frictions that drive the cost of traditional assets. The report expects several assets to be tokenized shortly.
- Growing demand for alternative forms of money: The demand for new forms of money, especially for money in tokenized form, has been rising quickly due to asset tokenization and other innovative business models made possible by blockchain technology. Several countries have already issued CBDCs. This poses a threat to nations that are yet to join this trend.
- The rise of DeFi as a key trend in the digital economy: The DeFi world has the potential to evolve and alter the present financial system and beyond the control of regulators. The DeFi space has surged over the last few years, attracting the attention of investors and new users.
The following characteristics would make a CBDC more desirable in light of these four trends:
1. CBDCs must not be complex. Instead, they need to be easy to use and widely accepted.
2. A CBDC should be supported by the blockchain, the technology that underpins the digital economy.
3. A CBDC must permit quick and affordable transactions. It may or may not be interest-bearing.
4. A CBDC must make it simple and frictionless for digital assets to be settled and exchanged for other digital currencies.
Creating Trust in a New Payment System
Ensuring that a CBDC maintains value as its physical equivalent is a key hurdle in issuing a CBDC. For CBDCs to gain wide adoption, there has to be trust in the new payment instrument. The trust factor is a crucial reason for the high cost of issuing cash. The central bank often has to take steps to prevent note forgery and safeguard the cash supply chain for people to trust it as a form of payment. Blockchain also has security features that make it challenging to fabricate CBDC issued on the ledger.
However, centralized ledgers are more susceptible to manipulation if the database is breached or otherwise corrupted. Therefore, according to the report, minimizing cybersecurity concerns will be crucial for centralized digital currencies.
Cash transactions have immediate settlement closure. Therefore, the digital analog of money must likewise have an immediate settlement finality. If not, the instrument would be subject to counterparty risk, negating some advantages of establishing a CBDC.
CBDCs can leverage the blockchain security features as an advantage over cash, thereby creating trust. In addition, a CBDC is considerably simpler to track the movement of and spot fraud than cash.
CBDCs and Privacy
Privacy is a fundamental human right and a prerequisite for widespread adoption. As a result, it is crucial to carefully strike a balance between this right and the necessity for the transactions to be KYC/AML compliant, especially in the context of retail CBDCs.
According to the report, this necessitates a multi-layered privacy strategy with movable privacy thresholds for entirely private, partially private, and fully transparent transactions. The report further states that it is crucial that central banks have complete control over and the flexibility to alter the thresholds between the various layers of privacy.
To address this privacy/transparency continuum, Algorand does not enforce a one-size-fits-all approach. Instead, the blockchain platform offers a flexible framework that enables governments and central banks to define their own levels of privacy using a mixture of built-in functionalities and sophisticated Layer 1 smart contracts.
Ensuring the Interoperability of the System
Designing a new payment instrument comes with a series of challenges. One of the most complex parts of this task is building protocols and processes robustly and stably that are interoperable with legacy systems and future requirements. The “openness-by-design” architecture of Algorand addresses this concern. It creates an environment that enables uncomplicated and smooth interaction between various ecosystem partners, such as e-money firms, banks, and payment providers.
The Algorand system ensures accessible communication and privacy. So, CBDCs launched on Algroand can leverage these features to be transparent and interoperable.
In conclusion, the growth of private digital assets has sparked a wave of innovation among huge banks, large corporations, and small startups. Algorand sees several projects joining its ecosystem to participate in the Web3 space and outside of regulatory view. The growth of private participation has resulted in transactions worth billions of euros. Governments are missing out on these digital innovations and transactions. But a state-sponsored digital currency can ensure their participation.
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