Bitcoin is probably the most exciting invention since the emergence of the Internet in the 90s. We have previously examined in our blog, how Bitcoin satisfies the main functions of money. The role of central banks is still essential for modern economies, however many experts claim that cryptocurrencies can replicate and even innovate the functions of a central bank.
The launch of Central Bank Digital Currencies (CBDCs) is the first attempt of policy makers to address this concept. This blog post examines the functions of central banks and how they compare to the functions of an open, permissionless cryptocurrency like Bitcoin. Consequently, we also evaluate how CBDCs mimic central bank functions and whether we actually need them.
Functions of a Central Bank
Central banks are the financial entities that monitor the banking and monetary systems of their regions. Regions can include individual nations or currency zones. Let’s take the example of the European Central Bank (ECB) that controls Euro’s monetary system. Consequently, Euro’s price stability and inflation levels depend from the actions of the ECB.
Besides monitoring price stability and controlling money supply, a central bank defines the regulations that national banks must follow. In addition, the credit/debit ecosystem must follow specific regulations that the central bank imposes. More importantly, a central bank is “the lender of last resort” for banks and other financial institutions. This means that central banks can provide liquidity to commercial banks when they operate under difficult financial circumstances.
According to ECB the main functions of a central bank that help achieve Euro’s price stability are the following:
- Monetary policy
- Statistics
- Financial stability and macroprudential policy
- Banknotes
- Payments & securities
- European relations
- International affairs
- Foreign reserves and own funds
- Foreign exchange operations
Central Bank vs. Bitcoin
Bitcoin has the technical attributes to replicate national currencies to a great extent. In fact, from the users’ perspective, Bitcoin enhances many fundamental positive functions that are not found in traditional fiat currencies. This led to a negative stance of central banks towards Bitcoin during the early years of its launch. However, the positive hype around cryptocurrencies seems to make policy makers reconsider their stance.
Let’s see whether Bitcoin can compare with central banks in terms of their main monetary functions.
- Regulation – There is no central authority that supervises whether the rules of the Bitcoin network are followed. However, the Bitcoin code is open source and the network has the ability to reject and ban malicious nodes that attempt to change the monetary rules.
- Stability – While central banks attempt to achieve monetary and financial stability through respective policies, Bitcoin achieves a programmable monetary policy. The money supply halves every 4 years until it reaches zero by approximately the year 2140. Only if the majority of miners alter the code, the monetary supply can be affected. However, such an attempt will damage the reputation for Bitcoin and therefore is not beneficial to implement for miners. In addition, Bitcoin does not act as a “lender of last resort” for any party that is into challenging financial circumstances.
- Financial Infrastructure – A central bank can print money at will (which can cause hyperinflation), while Bitcoin miners algorithmically receive block rewards. These block rewards increase the supply at a diminishing rate over time. Furthermore, Bitcoin holders do not need banking nor financial authorization and Bitcoin transfers are unlimited and global. While central banks depend on a variety of payment and settlement systems to operate, Bitcoin operates according to the network rules. On another note, traditional banking procedures maintain user protection via AML/KYC procedures, while Bitcoin owners operate in an open, transparent and permissionless network. However, they own full control and responsibility to keep their coins safe and within legal boundaries. Wallet functions like multi-sig can help reduce fraudulent activities.
The money supply is a tool for central banks to implement macroeconomic stability and growth. On the other hand, Bitcoin advocates witness the protocol as a fair incentive mechanism to maintain stability within the network. Lending and borrowing functions are also integral services of traditional banking.
Bitcoin does not offer these services, but several DeFi protocols like Aave are processing millions of dollars in decentralized lending and borrowing activities.
Bitcoin vs. CBDCs
CBDCs can act as payment and settlement tokens and decrease the reliance of central banks on cash. The first versions of CBDCs are denominated in the value of the corresponding national unit of account and issued by a central bank. There has not been wide adoption of the concept as only a few countries like Bahamas and Singapore are piloting the concept.
A retail CBDC serves a similar role as central bank money for the public, depending on the monetary policy of the country. It is legal tender, medium of payment and pegged to the corresponding fiat currency. The difference between a retail CBDC and traditional money is that it will adopt benefits of a blockchain network like fast settlement, traceability and 24/7 availability of transactions.
A wholesale CBDC improves settlement efficiency by replacing or co-existing with central bank reserves. Currently, central banks use the debit-credit system instead of actually transferring monetary values between accounts. Wholesale CBDCs can eliminate intermediaries associated with the costly and time-consuming debit-credit card system of a country.
A retail CBDC would be the monetary tool for the public. It is basically a claim on central bank, therefore it is still up to the central bank to record balances and handle payments and KYC processes. Probably, the public in order to use CBDCs, will have to go through identification procedures. The degree of anonymity will be minimum, unless a token-based retail CBDC is developed. In such a case, people could spend it with their private keys.
Another issue is the interoperability between different CBDCs. Central banks have not yet worked together to address the communication aspect. The only viable solution now looks to be the trading of CBDCs in exchanges and liquidity providers.
Based on the above, why would a CBDC be more needed than Bitcoin for the public? CBDCs can indeed improve interbank infrastructures, remittances and diminish costs and transaction times. But wait… these are already solved by Bitcoin! And more importantly, in a more transparent and efficient way. It seems that CBDCs are mostly an attempt of banks to make users believe they are adopting a “regulated” and “safe” version of cryptocurrency.
The reality is that Bitcoin replicates a real time gross settlement system in a more efficient manner! The only obvious drawback is that as adoption increases, scalability issues arise. Central banks can already handle large volumes of transactions, while cryptocurrencies depend on block size and Layer 2 solutions to scale.
