How CBDCs Will Impact Global Payment Systems

The original goal of blockchain technology was to make decentralized digital currencies possible. Bitcoin creates a decentralized digital ledger that tracks transfers of Bitcoin between parties. After Bitcoin, many new digital currencies were introduced with varying purposes.

Most modern cryptocurrencies are designed to be decentralized currencies with no direct link to fiat currencies. CBDCs are different, using blockchain technology to create a digital version of a country’s currency.

A CBDC will be created and managed by the country’s central bank, similar to traditional fiat currencies. However, it will function similarly to a cryptocurrency, recording account balances and transactions on a blockchain’s digital ledger.

CBDCs create digital versions of trusted, fiat currencies. This new technology has numerous potential impacts, including the following:

Historically, access to financial services has been limited, with some unable to open a bank account and use other services. This is true both within a country and, more generally, in countries with limited financial infrastructure.

CBDCs implement financial infrastructure on global blockchains, dramatically expanding who has access to financial services. This both enables it to better serve the unbanked and underbanked and can expand the pool of users for blockchain-based services.

Many common financial services are slow and expensive. For example, it’s not uncommon for a wire transfer to take days to complete and cost at least $25 to send, regardless of the amount.

In contrast, blockchain transactions are significantly faster and cheaper. For example, a Bitcoin transaction may be completed within an hour—with three confirmations—and costs roughly a dollar in fees.

CBDCs enable central banks to offer users the improved efficiency and cost of blockchain technology. At the same time, users can perform transactions using a known, trusted, and bank-backed currency.

Traditional financial services rely heavily on the assumption that individuals will turn to banks for saving or borrowing money. With significant cash reserves, financial institutions can invest and lend money for various purposes.

However, with the advent of Central Bank Digital Currencies (CBDCs), users might prefer to save in CBDCs rather than traditional fiat currency. This shift could lead to a decline in deposits held at banks, as individuals may simply keep their CBDCs in digital wallets instead of investing them in traditional savings accounts. Consequently, traditional financial institutions may face reduced liquidity, limiting their ability to invest and lend effectively.

This reduction in liquidity could accelerate the transition of financial services to blockchain-based platforms. Decentralized Finance (DeFi) protocols offer many of the same services as traditional banks but operate using smart contracts and blockchain technology. As users increasingly invest their digital currencies with DeFi platforms, these platforms could assume the traditional role of banks, potentially expanding the range of available financial services through the enhanced capabilities of smart contracts.

Traditionally, fiat currencies must be transferred between countries via correspondent banking networks. These systems are relatively centralized and can charge high fees, making it more difficult to transfer money across the world or to convert between various currencies.

With CBDCs and other digital currencies, international transfers are more efficient and transparent. As a result, many of the traditional silos are broken down for international transfers.

However, this also has the potential risk of increased currency substitution, where a foreign currency becomes the default within a nation. The traditional financial infrastructure provides a certain level of protection against this, but CBDCs increase accessibility and citizens’ ability to save and transact using whichever currency they prefer.

Traditional financial infrastructure is relatively opaque. Without the powers of law enforcement or the use of illegal methods, it can be difficult to “follow the money” from its source to its destination. This has both its benefits (privacy) and its downsides (illegal activity).

A CBDC records all transactions on the blockchain, which is a publicly-visible digital ledger. This eliminates the traditional opacity of the financial system, for better or worse. On the positive side, it can be easier to track digital currency transactions than those using fiat currencies. 

On the negative side, digital currencies allow anyone to know the balance of a particular account and enable tracking of “patterns of life” and transactions between one account and those it transacts with.

Traditional financial institutions face their own security challenges. They are a major target for cybercriminals, and banks can and do suffer cyberattacks.

CBDCs trade many of the security risks of traditional banks for those of the blockchain. Blockchain hacks are common, often due to the relative immaturity of the technology and the fact that lack of regulation means that many systems are implemented without following security best practices. The introduction of CBDCs may address some of these issues by providing governments with the incentive and a platform for issuing more stringent regulations.

The introduction of CBDCs has numerous potential implications for the financial industry. These solutions marry blockchain technology to fiat currencies, creating centrally issued digital currencies with all of the benefits of cryptocurrencies.

This approach has numerous potential benefits, including improving access, efficiency, and cost of digital payment options. However, it also introduces numerous potential risks, including the threat that these systems might threaten user privacy or be exploited by an attacker.

When creating digital systems that control large sums of money, it’s vital that designs and implementations are carefully reviewed and tested to minimize their vulnerability to attack. For help with enhancing the security of your DeFi project, get in touch with Halborn.