Central Bank digital currency to spell the end for crypto?

Do the central banks have a digital master plan in place that will see them derail bitcoin and other cryptocurrencies before they have truly been established as a viable, decentralised alternative to fiat?


Working for a global financial services firm that offers access to the markets for more than 1.5 million investors via our online trading platforms has enabled me to see a wide range of market participants’ views. Currently I am interested in why central banks’ embrace of all things digital could put cryptocurrencies on the road to nowhere. Even central bankers must worry about their job security. You would think having a monopoly on something everyone needs would make your profession pretty secure, but central bankers would disagree. The recent announcement that Facebook, with its 2.7 billion users (one-third of humanity), was stepping into the money-transfer business shocked the world’s central bankers. With its unparalleled reach and cutting-edge technology, Libra (now renamed Diem), could become the de facto standard for global payments, thereby undermining the banking system and creating a host of problems for monetary authorities.

As a prime example of where we could be headed, here’s how the International Monetary Fund (IMF) described the writing on the wall for central bankers in a policy paper titled ‘Digital Money Across Borders’ in October 2020: “A single global stablecoin (GSC) becomes commonly adopted in many countries and replaces the local currency as store of value, means of payment, and unit of account; and is also widely used for international transactions. This scenario may arise if a big tech platform of global scale decides to launch a GSC to its large customer base which spans across the globe. In this case, adoption will be driven by the network externalities associated with the existing large customer base as well as the synergies between the coin and other goods and services that the platform offers.”

“Such a GSC could initially be issued against assets denominated in existing reserve currency. Given the vast scale of the customer base of the big tech platform, the GSC could be adopted globally at a rapid pace. And the launch of a payment instrument that is catered specifically to its customer network would help strengthen its business model. As the GSC gains popularity, network effects would take over: agents would start invoicing contracts in the GSC and financial intermediaries would start collecting deposits and lend through GSC-denominated contracts. At some stage, once adoption reaches some critical mass, the peg to existing reserve currencies may no longer be needed to generate trust in the value of the GSC, and the GSC could become a fiat currency.”

In short, the financial system is vulnerable to ‘creative destruction’ and if it doesn’t keep up with the times, the banking systems that had worked so well for so long could be disintermediated and left behind, just like the landline telephony business. The response has been a flurry of research into central bank digital currencies (CBDCs). According to a recent survey by the Bank for International Settlements (BIS), 86 percent of the 65 central banks polled are actively researching CBDCs, 60 percent are experimenting with the technology and 14 percent are deploying pilot projects.


The case of the Bahamas
One case that could support the early promise is the ‘sand dollar’ in the Bahamas, an initiative that was rolled out in October 2020, making it the first country with a functioning national CBDC. The digital currency uses a simple two-tier system that is becoming the consensus structure among central banks, because it keeps the banking system and its essential functions intact. In this two-tier system, the central bank creates and issues digital currency to banks, which in turn distribute it to the end-users. The mechanics of how the Bahamian sand dollar gets into circulation is essentially the same as that of the conventional Bahamian dollar, except that the whole process is digital. No armoured trucks moving bags of cash around.

Bahamian dollars from the Central Bank of the Bahamas (CBB) reach citizens by the CBB selling cash to commercial banks; yes, banks have to buy cash. Banks pay for it with reserves they hold at the CBB. The banks keep the cash in their vaults. When customers want cash, they get it from an ATM. The bank deducts the amount from their accounts. Sand dollars, however, reach citizens by the CBB selling sand dollars to commercial banks. Banks pay for them with reserves they hold at the CBB. The banks keep the sand dollars in a digital vault. When customers want digital cash, they download it from the bank into their digital wallet. The bank deducts the amount from their accounts. The whole process is indistinguishable from cash, but it happens digitally, not physically.

As of October 2020, some Bahamians have been paying with sand dollars via a mobile phone application or a physical payment card. This payments and clearing process works as simply as cash does, while being far more secure. The added bonus is that if you lose your digital wallet you don’t lose your money. The sand dollar is only usable in the Bahamas. But when major currencies such as the US dollar or the euro go digital, seamless global secure money transactions will be possible at the touch of a button. For example, China, Hong Kong, Thailand and the UAE are currently working on a joint cross-border CBDC project, formally known as a ‘multiple central bank digital currency bridge’ (m-CBDC). The plan is eventually to extend the project to all major countries.


Questioning digital currencies
In my view, this development raises an existential problem for cryptocurrencies such as bitcoin: what will be the raison d’etre for cryptocurrencies once CBDCs become ubiquitous? Why would someone prefer to let Facebook’s Mark Zuckerberg look after their money rather than Fed Chair Jerome Powell or ECB President Christine Lagarde? And who would prefer to hold their money in an unsecured exchange like Mt. Gox, an entity that was hacked in 2014 while losing $460m in the process? Other crypto exchanges have collapsed due to outright fraud – Turkey’s Thodex exchange was taken offline after its founder absconded with $2bn in bitcoin-denominated client funds.

Indeed, why do bitcoin or other cryptocurrencies have any value to begin with? The key to that is their generic name: cryptocurrencies. Bitcoin and others have been promoted as a superior upgrade to managing a financial system, as opposed to ‘fiat’ US dollars and euros that are susceptible to debasing and devaluation by reckless monetary authorities. Early adopters and buyers are expecting greater demand in the future, but why exactly should demand increase?

One assumes it is because they expect people to use them for two of the three uses of currencies: a medium of exchange and a store of value.


The Quora question
I got that view from Quora, a website where users can ask questions and provide answers to both the mammoth and mundane alike. I’m active on Quora to field questions related to finance. I’m routinely asked questions such as: what will happen to the world when cryptocurrency takes over? Are cryptos becoming a western response to the possible fall of the fiat-US dollar standard? Have any countries stated that they are building up reserves of cryptocurrencies like bitcoin and ether? And will bitcoin become the reserve currency of the world?

It seems silly to me that what underpins bitcoin sentiment is the idea that, over time, people will use it more, and that will generate higher demand (and prices). But here’s the rub. Why would someone use bitcoin – or any other cryptocurrency, for that matter – if there are alternatives such as ‘digi-dollars’ and ‘e-euros’? Moreover, why would they choose bitcoin if government-backed alternatives can do it just as quickly, only with a zero bid/offer spread and military-grade security to negate lingering concerns regarding hackable wallets? The answer to this question is that people are likely to go for the easier solution, which is CBDCs.

The adoption of CBDCs is likely to dispel the illusion that cryptocurrencies are ‘currencies’ in the true meaning of the term and scuttle their aspired goal of becoming cash equivalents (see Fig 1). As many policymakers have pointed out, including former Bank of England Governor Mark Carney and Swiss National Bank President Thomas Jordan, cryptocurrencies are crypto-assets, not currencies. People are buying them simply in the hope of selling them at a higher price in the future. But if CBDCs occupy the niche in the financial sector that cryptocurrencies are expected to occupy, why should demand increase? Eventually, people are likely to realise that cryptocurrencies are no more than digital goods. They may still undergo extreme price inflation – think of the digital kitten that reportedly sold for $172,000 in 2018 and the digital dress that sold for $9,500. Although, these kinds of items typically serve a function in an online game or carry aesthetic appeal that gives them value.



Cryptocurrencies, on the other hand, are restricted to a limited role in online gaming and you can’t wear them in photographs, so even their role as virtual goods is questionable. If CBDCs are eventually introduced as a counter to cryptocurrencies, it will only be a matter of time until people realise that cryptocurrencies have no real futures as trustworthy currencies, and therefore, are likely to have limited value as assets. But yes, I do wish I had bought a wallet full of bitcoin at 50 cents in 2011.


Supply and demand
I passed the ideas in this article by a few online cryptocurrency enthusiasts. Needless to say, they staunchly disagreed. They argue that bitcoin and other such coins are not currencies at all – which I agree with – but rather stores of value deemed superior because of their independence from irresponsible monetary authorities. They contend that no respectable bitcoin holder would abandon it in favour of central banker-sponsored digital versions, which the monetary authorities can debase at will.

However, I have my doubts. Most importantly, the idea that bitcoin is a store of value is based on the premise that its total production is limited. But with bitcoin derivatives already available, that’s no longer true. The connection between supply and price has been severed. Nor is the supply of cryptos limited; on the contrary, there are over 2,000 of them. Three-quarters have already fallen by the wayside, taking everyone’s money with them. This demonstrates my other objection: there are many things in limited supply that are not particularly valuable.

Scarcity is a function of demand as much as supply.