CBDCs in Focus This Year: Will These be the Bitcoin Killer?

Today, China, Sweden, Nigeria, and The Bahamas are among the few countries with CBDCs in use or in advanced testing. However, policymakers in the US, the UK and Europe have signalled that they are seriously considering their own CBDCs. The Bank of International Settlements’ (BIS) 2021 Annual Report found that 86% of all central banks see promise in CBDC development.

At a cursory glance, CBDCs can seem like a government-backed alternate to cryptocurrencies. Like crypto, CBDCs are designed to facilitate digital payments. However, these currencies might even be better than their highly volatile counterparts. In 2018, prominent economist Nouriel Roubini predicted that CBCDs would “destroy bitcoin”. The risk to existing cryptos, coupled with the intrigue of a new form of money, means that CBCDs will spend the coming years in the limelight. How does this affect investors, and does it mean winter for cryptos?

Why CBDCs

In the traditional landscape, using the US as an example, only commercial banks hold reserves at the Federal Reserve. The member banks use these reserves to meet their daily payment obligations. Any shortfall (or excess) on these obligations is borrowed from the overnight interbank money market. The reserves are a crucial interest rate tool. Paying banks in reserves in exchange for assets increases supply in the overnight market and lowers the cost of borrowing for banks. Since these reserves are digital transfers between Fed ledgers, they are extremely low cost.

Entities that do not have reserves at the Fed do not have access to this low-cost payment mechanism. Instead, they rely on commercial banks and non-banking financial intermediaries to complete their payments. These institutions often charge a fee for this service. Ernst & Young estimates that a typical bank makes between 20%-30% of their profits from such payments. These fees can get even more significant for cross border remittances. In addition, even in advanced economies like the US, many underbanked individuals still rely on costly intermediaries, such as check cashing services and money orders.

CBDCs offer a solution. They are digital tokens pegged to the issuing country’s currency and backed by the trust in their government, just as currency is. CBDCs will be deposited directly into the accounts of individuals and companies and transferred between central bank accounts with the same ease and cost efficiency as bank reserves.

For international transfers, a collaboratively supported central bank platform can lower cross-border payment costs by $100 billion, as per JP Morgan and Oliver Wyman Research. Such a network will need a commonly accepted single system and ruleset. An m-CBDC bridge project is in the testing phase by monetary authorities of China, Hong Kong, Thailand, and the UAE.

Do CBDCs Herald a Long Winter for Cryptos?

The crypto-winter is an epithet used to describe the crypto-market downturn of 2017-18, during which crypto bellwether bitcoin (BTC) fell over 82%. Will the launch of CBDCs wreak similar havoc in the market?

Stablecoins offer a cryptocurrency solution to high-cost payments and are likely the most vulnerable to CBDC introduction. The value of stablecoins are pegged to a reserve asset, such as the dollar or gold, and can be transferred at low costs between wallets. Bank of America analysts expect the use of private stablecoins to surge in the coming years, driven by cross border payments. They have also been controversial, with analysts questioning whether operators held sufficient asset reserves to keep the value pegged. Governments share these concerns. The Biden administration endorsed the potential of stablecoins as a transfer mechanism, but only in a regulated environment and when issued by insured banks. Private stablecoins could lose the fight in the long term, with the better backed CBDCs being stabler and a potentially cheaper mode of transfer.

At the core of the crypto community is a fundamental belief in decentralisation and low censorship. As a central bank liability, CBDC transfers will be trackable, with the KYC requirements of the accounts making it easy for state actors to identify senders and recipients of. This monitoring helps alleviate the risk of CBDCs being used in a crime or stolen as cryptos have been. However, malicious state actors could potentially prevent CBDCs from being transferred to businesses and individuals they do not view favourably. Cryptos can still find value in ensuring the anonymity and safety of its participants.

In addition, Decentralized Financing (DeFi) is a quickly growing facet of the crypto world. Built on smart contracts on networks like Ethereum, DeFi eliminates the need for financial intermediaries in functions such as investing and lending. Instead, they are conducted by completely transparent algorithms. CBDCs do not seek to compete with the DeFi space. Instead, in a CBDC regime, financial institutions are still required to facilitate investment and decision making.

Moreover, bitcoin is widely seen as a hedge against inflation, akin to gold. This utility will not be upended by a fiat pegged CBDC with the same inflation risks.

There is also a significant question regarding how far CBDC adoption would go. No doubt, CBDCs are a superior product to bank accounts and cash. It offers central banks access to a robust and monitorable tool to combat credit and asset bubbles, stave off bank runs, and oversee the quality of bank lending. However, that degree of control will mean it is simply a digital version of the fiat currency. CBDC adoption may not curb the demand for cryptocurrencies.

Although the leading cryptos seem to have lost favour so far this year, after reaching record highs in 2021, there’s no debating their wide adoption. This has been driven by a rapid increase in global liquidity (with governments disbursing funds amid the pandemic), easing barriers to crypto purchases, and crypto adoption by institutional investors. There seems to be further downside ahead, as can be seen on the Acuity Trading Dashboard.

However, crypto markets are not in the doldrums, and it’s definitely not winter for them. Even traditional investors like Warren Buffett have come around. Buffett’s Berkshire Hathaway has dumped legacy financial stocks like Visa and Mastercard to spend $1 billion in crypto investments.

CBDCs are inevitable and are another step towards bringing currency fiat into the digital age. They are critical in designing a more efficient payment interface, providing a more controlled and directable monetary tool. But they cannot replace cryptos. Instead, they may even boost cryptos. Michael Sonnenshein, the CEO of Greyscale Investments, the largest digital currency asset manager, said in an interview with CNBC that CBDCs could “serve as a tailwind for investors and businesses to look into cryptos”. While cryptos could lose some value as large economies launch CBDCs, they may have found their specialist niche in applications like DeFi.