The narrative surrounding central bank digital currencies (CBDCs) has progressed significantly over the course of the last financial year. CBDCs have evolved from a largely theoretical discussion to a stage where they are going through various stages of research and development to see how they might function in practice.

China’s digital yuan is now the most valuable digital currency in the world, surpassing the US dollar in terms of market capitalization. With the help of a variety of pilot programs, the Chinese government hopes to expand use of the CBDC to a total population of more than a billion people by the end of this decade. The United States has made significant progress in CBDC development in recent years, despite the fact that no other country has yet attained the same level of development as it. Recently, the finance ministers of the G7 countries convened and came to an agreement on a set of defining principles for CBDCs. However, outside of China, some of the most notable outcomes are now appearing from Asian countries outside of the country.

Particularly noteworthy are the initiatives of the Hong Kong Monetary Authority (HKMA) and its joint attempts in this regard. HKMA has been investigating the potential of creating a CBDC since 2017. In the first instance, nicknamed Project LionRock, it looked at the notion of a so-called “wholesale” CBDC, which would be a digital currency that could be used to settle financial transactions between banks.

By 2019, it had formed a partnership with the Bank of Thailand to investigate the use of CBDCs for cross-border payment transactions. In light of the participation of the Central Bank of United Arab Emirates, the Digital Currency Institute of the People’s Bank of China, and the Bank for International Settlements (BIS), the collaboration has advanced to a new stage in the development of a multiple CBDC bridge, which has been dubbed mBridge and is currently in the early stages of development.

The most recent development, on the other hand, is the one that has the greatest potential to alter the status quo. CBDCs, in particular, pose an existential danger to the permissionless financial system to which crypto has grown accustomed over the years.

In a white paper produced by the Hong Kong Monetary Authority (HKMA) in the first week of October, experts in monetary policy, banking, and distributed ledger technology were asked for their opinions on the possibility of the introduction of an electronic Hong Kong dollar (e-HKD) in the territory. Many issues are presented in the paper, including the distribution of monetary responsibility between central banks and the banking sector, among other things. But for those of us who work in the blockchain and cryptocurrency sectors, there is a lot more to worry about than just that. More information may be found at Hong Kong Monetary Authority Releases CBDC White Paper to Examine Prospects of e-HKD, which is a Chinese language version of this article.

It is not clear what technological infrastructure will be required for a CBDC, but the document welcomes comments on seven “problem statements” that are raised throughout the paper. A retail CBDC’s technology-enabled functional capabilities, as well as its privacy and interoperability, scalability, and performance, cybersecurity, compliance, operational robustness, and resilience, are all key factors to make it work.

Need for CBDCs

Any enterprise or organization that has explored deploying blockchain or decentralized ledger technology has likely been confronted with some or all of the questions listed above at one time or another. All of these questions ultimately boil down to one question: Do the advantages of a permissionless, open, and decentralized public network such as Ethereum outweigh the disadvantages? Alternatively, would a permissioned implementation be a preferable choice?

In the context of CBDCs, the decision between permissioned and permissionless ledgers has far-reaching ramifications for the organization’s operations. Providing an adequate answer to one of the problem statements will invariably result in issues in the remaining problem statements.

For example, we could make a safe assumption that a central bank would not want a CBDC to provide the same level of pseudonymity as a cryptocurrency such as Bitcoin or Ethereum and would take advantage of the chance to incorporate compliance-based safeguards into the design of the architecture. The need that a user undergo know-your-customer (KYC) and anti-money laundering (AML) procedures before to creating an account is a clear illustration of this. When it comes to identification checks, however, there are legitimate worries about government monitoring and user privacy. These concerns must be weighed against the need to facilitate financial law enforcement and prevent CBDCs from being used in illicit activity. When it comes to balancing operational robustness and resilience with cybersecurity, there is a trade-off that is comparable to that described above. Because of the sheer magnitude of their networks, permissionless blockchains such as Ethereum and Bitcoin have demonstrated over a long period of time that they are extremely resistant to attacks. Allowing for participation and building a highly robust architecture that is prohibitively expensive to attack are two benefits of the permissionless model.

However, there are certain disadvantages from the CBDC’s standpoint, the most prominent of which is a lack of control over performance and scalabilityThe process of updating public blockchain networks may be time-consuming, especially when it needs agreement from a majority of network members, which is difficult to achieve in a decentralized network setting. A central bank would be unlikely to relinquish complete governance power over a national currency to a decentralized network, even if it were possible to verify that all of the network members were honest and that the breadth of authority was constrained in some way. Finally, it looks that a permissioned implementation of some kind will be successful in the long run.

Central banks, on the other hand, will have to find ways to address privacy and security concerns without jeopardizing their requirement for compliance, control, and overall performance.

What does it mean for stablecoins?

One factor that is absent from the HKMA report, and indeed from the CBDC debate as a whole, is the potential of decentralized financial institutions (DeFi). Cryptocurrency’s unique features and advantages, such as the capacity to generate programmable money with automated transactions governed by smart contracts, prompted the emergence and evolution of DeFi in response to these characteristics and advantages. Traders can take advantage of arbitrage opportunities in the moment and settle payments of any amount almost instantly, 24 hours a day, seven days a week, from anywhere in the globe, thanks to the Internet. Therefore, CBDCs have the potential to make a significant difference in the broader global asset markets.

This, however, poses a slew of challenging questions regarding the long-term viability of stablecoins. As the value of crypto and digital currency exchanges has increased, and institutional interest in these markets has increased week after week, regulators have become more loud in their call for caution. Gary Gensler, the chairman of the Securities and Exchange Commission in the United States, recently referred to stablecoins as “poker chips,” and it appears that law overseeing dollar-like digital analogues is only a matter of time.

A topic that is becoming increasingly important to lawyers, analysts, and consultants from a wide range of backgrounds in the crypto, financial, and technology industries McKinsey & Company recently published its own assessment of the matter, suggesting that while regulated stablecoins and CBDCs could coexist, it is equally likely that one will prevail over the other.

At the outset, it’s important to point out that CBDCs offer a number of distinct advantages over stablecoins. First and foremost, as previously said, CBDCs provide the flexibility to incorporate compliance and digital identification aspects into the design from the beginning. The rules of the platform govern stablecoins, which are issued across various blockchains and operate within their respective platforms.

Moreover, CBDCs have the potential to automate the collection and distribution of taxes, alleviating yet another issue for financial institutions. Tax is withheld at the source in several jurisdictions, such as Switzerland, on certain transactions, such as those involving foreign residents, to ensure that they are tax efficient. If tax evasion is suspected, banks are required to cooperate with disclosure demands issued by the appropriate authorities in all nations.

Conclusion

Given these advantages, if faced with a choice between CBDCs and regulated stablecoins, CBDCs would be the clear choice for practically all financial institutions, regardless of their size.

Because of the numerous challenges involved in developing a retail CBDC, it may be several years before the true impact of the CBDC is fully realized. However, it is already clear that CBDCs will create significant opportunities for the financial system, but they may also pose an existential danger to stablecoins and the current DeFi landscape if they are allowed to continue to operate.