What Are Central Bank Digital Currencies?

Happy Friday, everyone! 🤗 

Bitcoin has had a great week, rising more than 11 percent in the last five days.

Bitcoin is also starting to get more media attention again. It's funny (and sad) how the only thing that brings Bitcoin into the mainstream media is the price action.

Bitcoin price goes 📉 → mainstream media goes 'Bitcoin is dead' 💀 

Bitcoin price goes 📈 → mainstream media goes 'Bitcoin is back' 💥 

Expect a lot of media attention (including lots of 💩 takes) as the ingredients for the next bull run are coming into play (namely the Bitcoin ETF and the next Bitcoin halving). Just stay calm and read this newsletter.

As promised, I'd like to zoom out a bit and take a look at the wider crypto landscape and its various coins, tokens, and projects to understand how they all differ from each other.

So today, let's take a look at Central Bank Digital Currencies (CBDCs). You may have heard about CBDCs in the news. They are governments' answer to cryptocurrencies. And they are often portrayed as something very dystopian. I count myself among the sceptics.

So for this issue, I spoke to Mark Monfort. Mark is the co-founder and director of the venture studio NotCentralised. In this role, he was involved in a CBDC pilot project led by the Reserve Bank of Australia. So let's get started!

Mark, in simple terms, what is a Central Bank Digital Currency (CBDC)?

A CBDC is essentially a digital form of a country's currency, issued and regulated by its central bank. It operates under the central control of its issuing country, ensuring stability and reliability similar to traditional money, but in a digital form. 

CBDCs have been a controversial topic among those in the crypto space, due to the potential risks of excessive monitoring of transactions. 

But it's important to understand the differences between the types of CBDCs out there, as well as the different ways in which distributed ledger technology is used under the hood.

For clarity, let's draw a few lines in the sand. What's the difference between a CBDC and physical cash, money in my bank account, and a cryptocurrency like Bitcoin?

Physical cash is tangible, anonymous, and requires no digital infrastructure.

Money in a bank account is a digital representation of physical cash, held and managed by commercial banks.

A cryptocurrency such as Bitcoin is decentralised, not issued by a central authority, often volatile, and based on blockchain technology.

CBDCs are digital, typically centralised, issued by a country's central bank, stable, and designed to replicate the characteristics of physical cash in a digital ecosystem.

Why are governments considering establishing CBDCs?

Governments are considering introducing CBDCs to modernise financial systems, improve transaction efficiency, counter the rise of cryptocurrencies, and maintain control over monetary policy in a digital world. 

There are also different ways in which these national CBDCs could be designed, so we could see some with an inability to trace transactions or some where it is only available at the wholesale level. 

Some countries have talked about limits to avoid the potential for bank runs from cash to digital, but some have seen this stance as a negative, evoking further government control of spending. 

Whatever happens, however, it will come down to the trust that citizens have in their government, and in countries where trust is lacking, a CBDC will struggle to be successfully introduced and used.

Which governments are leading the race for a CBDC?

Countries such as China, Sweden, and the Bahamas have been at the forefront of CBDC development. China's digital yuan and the Bahamas' sand dollar are notable examples. However, it's still very early days for the potential use of CBDCs.

Are all governments interested in establishing CBDCs? Or just authoritarian governments and dictatorships?

Interest in CBDCs is not limited to authoritarian regimes; it's widespread.

Democracies and authoritarian governments alike are exploring CBDCs, driven by a desire to innovate in financial technology and maintain control over national monetary systems.

Another important factor for governments to consider is that if others adopt electronic payment rails for their economies and they do not, they could be left behind and their economies disadvantaged.

Will Australia adopt a CBCD? When? 

Australia is actively exploring CBDCs, as evidenced by our pilot project with the Reserve Bank of Australia (RBA). While there's no official launch date, this exploration indicates a forward-thinking approach to the adoption of CBDCs in the future.

Earlier this year, the RBA completed its pilot with 15 third-party projects running on a private version of Ethereum to test how parts of the technology could work. Over 150 projects had gone through the application process to test the tech.

This is certainly no indication of what the RBA will release in the future and was a step up from their previous project with a smaller group of participants. Careful and cautious was the approach, but it's great to see enough forethought to actually test the tech with blockchain.

Are all CBDCs the same? Or are there different kinds of CBDCs?

Not all CBDCs are the same. They can vary in terms of their accessibility (retail vs. wholesale), the technology they use, and the level of anonymity they offer. Each country's CBDC is tailored to its specific financial system and policy objectives.

Especially among Bitcoiners, CBDCs are perceived as a surveillance tool. What risks do CBDCs pose to freedom and privacy?

The perception of CBDCs as surveillance tools stems from the centralised nature of most CBDCs, which potentially allows governments to track transactions in real-time. This raises concerns about privacy and government overreach.

However, it's worth noting that the design and policy framework of a CBDC can significantly influence these aspects.

For example, if we think further, there could be designs in the creation of these CBDCs that add the ability to have privacy via Zero-Knowledge (ZK) proofs that obfuscate transaction amounts and other data to non-counterparties. The Bank of England is exploring a ZK proof solution for its privacy layer in the digital pound.

Will physical cash be phased out once CBDCs are introduced?

The introduction of CBDCs doesn't necessarily mean the end of physical cash. Many governments see CBDCs as a complement rather than a replacement for cash, at least for the foreseeable future.

Money has evolved over centuries and will continue to do so as technology drives innovation. These things don't happen overnight, so we're likely to see a transition period.

What many people forget in our crypto circles is that this has to be proven to be useful for everyday citizens. We still have a long way to go before crypto transactions are used by everyone in their everyday lives. We're getting there, but it's still early days.

As co-founder of the venture studio NotCentralised, you participated in a pilot project led by the Reserve Bank of Australia. You tested the use of a CBDC in the construction industry. Tell me what problem you solved with the CBDC, why you chose a CBDC over other payment rails, and what results you achieved.

We chose to put our hat in the ring for the pilot with the RBA to test the potential of a CBDC to address issues of trust and efficiency in financial transactions in the construction industry. Our use case works without a CBDC, but the opportunity to test the interaction between a stablecoin and a CBDC in a real-world use case was compelling.

The recent spate of collapses in the construction industry has highlighted the urgent need for more robust financial protection. Protections such as escrow are cost-prohibitive for smaller projects, but by using a digital escrow we created a more cost-effective system that mitigated risk for all parties involved.

Our escrow was based on a programmable stablecoin and the counterparties to the trade each transacted in fiat. The CBDC in this case acted as a proof of reserve with a 1:1 backing for the stablecoins. This is similar to how government bonds in equities represent a government promise and are seen as a highly trusted asset. The role of the CBDC was to provide an additional layer of trust and stability to the overall system.

In addition, the inherent transparency of blockchain is not always suitable for commercial transactions. To address this, we integrated ZK proof technology. This enabled transaction confidentiality, hiding transaction amounts from all but the parties involved, and ensuring privacy while retaining the benefits of blockchain.

As mentioned earlier, our project is not dependent on the existence of a CBDC. The use of stablecoins backed by a variety of assets ensures the viability and scalability of the project. We are actively engaging with a wide range of parties, both nationally and internationally, to explore the wider application of digital escrow services. This project is a testament to the practical application of blockchain technology in the real world, providing a more secure, transparent, and efficient way to conduct transactions in industries such as construction.

This pilot is an example of how new technologies can revolutionise traditional processes and provide tangible solutions to long-standing industry challenges. It's a clear demonstration of our commitment at NotCentralised to innovate and push the boundaries of what's possible in the digital and financial landscape.

That's it for today, everyone. Have a great weekend! 😎 

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