5MF Issue 5: Central Bank Digital Currency

In 2009, Satoshi Nakamoto mined the genesis block of Bitcoin and ushered in a new era of financial innovation. More than a decade later, governments and central banks remain confused about the implications of cryptocurrency for the future of money.

I'd like my Bitcoin without the blockchain, please.

In 2009, Satoshi Nakamoto mined the genesis block of Bitcoin and ushered in a new era of financial innovation. More than a decade later, governments and central banks remain confused about the implications of cryptocurrency for the future of money.

At the heart of Bitcoin and other cryptocurrencies is the concept of the blockchain, a distributed ledger that enables the reconciliation of transactions without the need for a central authority.


It is no coincidence that enthusiasm for electronic forms of currency has grown exponentially during the past decade: no government wants to lose its central position in the economy. If cryptocurrency is the future, governments need to figure out how to create electronic currency that can be centralized.

'Central Bank Digital Currency': Explaining the Word Salad 

The concept of electronic money has been around for at least a century. The US Federal Reserve first began discussing it when they began allowing banks to transfer funds by telegram in 1917. Interest grew more quickly during the past few decades, with the ubiquity of credit cards, the advent of the Internet & mobile payments, and most recently, the rise of cryptocurrency.

There is no established definition for 'central bank digital currency' (CBDC). This is partly due to the fact that the concept of 'money' is difficult to define. Money can generally be described as a 'widely accepted medium of exchange for goods and services'.

In order to understand digital money, we must consider four key attributes:

  • Form (digital or physical)
  • Issuer: (a central bank or other entity)
  • Accessibility: (wide or restricted)
  • Technology: (Token or Account-Based)

Although there are numerous exceptions, most government experiments want to create a form of CBDC that is digital, issued by a central bank, widely accessible, and token-based. Let's take a look at the benefits and risks of such a strategy.

Helicopter Money and the Benefits of CBDC

In a thought experiment in 1969, the economist Milton Friedman illustrated the effects of monetary expansion through the example of a helicopter dropping money over a city. The concept of 'helicopter money' has been more recently used to describe the positive impact of putting money directly into the hands of individuals, rather than trusting banks to distribute it in an equitable fashion.

This theory became reality during the COVID epidemic, when millions of Americans received a stimulus check signed by the President himself.

Money usually flows from the government to banks, before it is lent to individuals. Banks profit handsomely from this process, making money on the arbitrage between interest rates paid by the government vs what they offer to consumers.

A national, electronic currency would cut banks out of this process. In the US, individuals would be able to open accounts directly with the Fed, earning higher interest on their money. Individuals or institutions would be able to hold large sums of money in these accounts, since the US government would guarantee deposits fully, rather than the $250,000 guarantee that banks are able to offer through FDIC insurance.

CBDC could also increase inclusion for the millions of unbanked around the world. The government could offer deposits and other services to individuals without concern for minimum thresholds.

A centralized currency is fully trackable, making it much easier for the IRS to prevent tax avoidance. If cash alternatives were eliminated over time, the FBI would be able to track the location of every tokenized dollar in the US economy.

Monetary Interventions: Keynesians Gone Wild

Economists in favor of greater macro-economic intervention salivate at the idea of a digital currency. Central banks would have unprecedented capabilities to target specific socio-economic groups for stimulus efforts; people recovering from a fire or hurricane could receive recovery packages based on zip code.

While it is tempting to imagine the benefits of real-time, targeted interventions, they open up risks for abuse and unintended consequences. Politicians do not have a good track record when it comes to disciplined, sensible execution with their current toolset. Sharpening the knives makes the potential for abuse or unintended second order effects greater than ever.

The End of Privacy

Privacy is a core philosophical pillar of the cryptocurrency movement. To those in the movement, a centralized, digital currency is a nightmare outcome.

Governments would have access to the holder of every single unit of currency in their country. Nefarious government actors would be able to 'follow the money' to persecute detractors, target political rivals, or engage in blackmail. Of course, there are governments where these concerns have no weight.



The Digital Yuan and the Battle for Monetary Supremacy

In August, Beijing announced that it will begin testing the 'digital yuan'. This is a significant pilot, involving 400 million people (about 29% of the country's population).To date, the government has filed 130 patents in the domain of cryptocurrency.

China has been testing social-scoring systems for a few years; digital money is a natural extension of these efforts. There is no better fiscal tool for a command-and-control government than CBDC. Authoritarian regimes can take much greater advantage of a CBDC, since citizens are powerless to protest based on grounds of privacy.

The Chinese government also sees the digital yuan as a way of breaking the supremacy of the US dollar. This stands to reason. There is the definite possibility of a first-mover advantage for a digital currency that can increase monetary efficiency.


The Inevitable Rise of Digital Currency

To date, 80% of the world's governments have kicked off programs to research and test digital currency solutions. From Sweden to Uruguay, active tests have been underway for four years. The continuing rise of Decentralized Finance and Bitcoin will pressure several governments to make digital currency official during the coming years.

The effects of these efforts on our financial system remain an open question. 


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