What is a Central Bank Digital Currency (CBDC), and How is It Connected with Facebook-backed Diem?

There’s been a lot of discussion around central bank digital currencies (CBDCs) and how they are about to become “the killer app”. Will they live up to expectations, or disappoint us in a couple of years? Let’s find out.

What is a Central Bank Digital Currency (CBDC)?

A CBDC is a blockchain-based central bank digital currency released by the government as an alternative payment method. It is a crypto equivalent of a national currency that uses an electronic record or digital token to represent the virtual form of a fiat currency of a particular region.

Basically, there are two categories of CBDCs: retail and wholesale.

A retail CBDC is the one that is issued for the general public, common citizens. Such currencies usually include the features of availability, anonymity and traceability. They provide financial inclusion and might offer new opportunities for an interest rate application, which is crucial for emerging economies.

A wholesale CBDC, on the other hand, is made for financial institutions that hold reserve deposits in a central bank. They are considered as the most favorable alternatives to central banks since they could facilitate wholesale financial systems, while enhancing their speed and security and reducing costs.

In fact, CBDCs are still sort of an experiment rather than a widespread practice. They were introduced as a concept several years ago, followed by a quick launch of El Petro, a cryptocurrency issued by the government of Venezuela in February 2018.

Last year, CBDCs gained even more attention from a general audience when the Bahamas introduced the first nationwide CBDC in the world, Sand Dollar. They were followed by 11 other countries that have piloted a digital currency and 53 more currently conducting research and looking forward to CBDC integration. 

For instance, Sweden has already completed the first phase of their CBDC pilot, and China is ready to distribute over $3 million worth of e-CNY to Shanghai citizens as a part of their testing program.

Overall, 73 countries are experimenting with CBDCs at the moment.

So why have CBDCs become so popular?

Why do we need CBDCs?

There are distinct differences between CBDCs and regular cryptocurrencies. However, the difference between traditional finance and the potential CBDC ecosystem is even greater.

Why are governments interested in virtual currencies in the first place? According to the International Monetary Fund, there might be several reasons:

• CBDCs are centralized, which allows the government to control the money supply and assign particular entities to manage the distributed ledger. This can facilitate monetary policy flow and help the government focus on other bottlenecks, thus leading to economic stability.
• Compared to fiat money, CBDCs are much more cost-efficient due to lower transaction fees.
• They can potentially enable financial inclusion and security, granting the unbanked population access to money on their devices with no middlemen.
• Due to the essence of the DLT, CBDCs will enable tracking payments, allowing the central entity (the government in our case) to trace all the transactions performed in the network. This feature will help the authorities stop money laundering and prevent terrorist financing.

Still, there are a lot of challenges to overcome for full CBDC implementation. Mostly, these are regulatory processes that are totally out-of-date for such a technology and the problem of mass national adoption. But despite any inconveniences, several countries have already launched their own CBDCs.

Countries that launched a CBDC

Bahamas: Sand Dollar

As the Bahamas was one of the pioneers in CBDCs, let’s take a look at them first.

In 2019, the government started a Sand Dollar project, which took a whole year to be developed and implemented and was fully deployed only in October 2020. Island geography and frequent natural disasters prompted the Bahamas to launch a CBDC to modernize their payment systems.

“In an island geography it’s very hard to provide financial services through a physical channel. The cost considerations have meant that banks in some cases refused to service some of our rural “family islands.” Those communities can eventually piggyback off this [digital] infrastructure to communicate and interact with traditional financial-service providers,” - stated John Rolle, the governor of the Central Bank of the Bahamas.

Being a digital version of the Bahamian Dollar, Sand Dollar can be easily accessed by all residents through a mobile app or a physical payment card.

China: e-CNY (Digital Yuan) 

China started experimenting with a CBDC even earlier than the Bahamas. However, it took them much more time to launch the e-CNY currency.

Alongside the primary institution, the People’s Bank of China, other parties are also engaged in the development of the digital yuan.

At the moment, the digital yuan is one of the most successful CBDCs worldwide. It has reached $5.3 billion in transactions and is projected to engage 1 billion users in 10 years.

Such a rapid development might be considered a threat to the US dollar since China can become a monetary leader in the world economy. Some experts believe that this is an extra motivation for the US government to accelerate its own CBDC development.

“The United States should not rest on its current leadership in this area. It should push ahead and develop a clear strategy for how to remain very strong and take advantage of the strength of the dollar,” said Darrell Duffie, professor of finance at Stanford University’s Graduate School of Business.

Eastern Caribbean Area: DCash

The Eastern Caribbean CBDC was developed with the same thought in mind as the Bahamian Sand Dollar - to reach the unbanked part of the population. The main goal was to create a secure and cheap retail payment system for merchants and those citizens who don’t have credit cards.

This digital currency is being adopted in Antigua and Barbuda, Grenada, Saint Christopher (St. Kitts), and Nevis and Saint Lucia. After the 12-months pilot, DCash will be introduced to the rest of the islands of the Eastern Caribbean Area.

France: Wholesale CBDC

The French government has been experimenting with CBDCs for over a year after announcing their intentions in March 2020. 

At the end of June 2021, Banque de France conducted the most recent part of the research. Along with a group of participants connected with SEBA Bank, they successfully completed a simulated securities settlement using a wholesale CBDC.

“This experiment made it possible to demonstrate the possibilities of interaction between conventional and distributed infrastructures. It also paves the way for other alliances in order to benefit from the opportunities offered by financial assets in a blockchain environment,” explained Nathalie Aufauvre, General Director of Financial Stability and Operations.

Moreover, predicting the potential of CBDCs, France has initiated collaborative experiments with Tunisia, Switzerland, and Singapore for potential cross-border and cross-currency transactions.

Canada: Jasper

Canada claims to be the first country in the world where a central bank participated in a DLT experiment in partnership with the private sector. To investigate DLT and issue a Canadian CBDC Jasper, the Bank of Canada has cooperated with Payments Canada, financial innovation firm R3 Lab and Research Centre, CIBC, TD, Scotiabank, Bank of Montreal, RBC, National Bank, and HSBC.

However, the Bank of Canada has no plans to launch a CBDC any time soon. It is rather getting ready to issue Jasper in case the general public stops using fiat banknotes or adopts an alternative digital currency. Yet, such preparation will take several years.

Singapore: Ubin

In November 2016, The Monetary Authority of Singapore (MAS) announced that it is partnering with R3, a Blockchain technology company, and a consortium of financial institutions to research DLT and its potential for global payment systems.

In the next five years, MAS published technical documentation, delivered Delivery versus Payment (DvP) capabilities for transaction settlement, and conducted successful experiments on cross-border and cross-currency payments with CBDC. Eventually, MAS held workshops with over 40 different financial and non-financial organizations to evaluate the potential benefits of integrating blockchain-based payments.

At the moment, the Ubin network prototype developed during the investigation continues to serve as a test network to help MAS collaborate with other central banks and facilitate developing next-generation cross-border payments infrastructure.

South Africa: Khokha

The main goal of the project Khokha was to research further on CBDC and get insights on DLT developments in a South African wholesale payments context. Besides, the researchers were interested in how well the South African Multiple Option Settlement (SAMOS) system would work with a DLT system without implementing changes to it.

As a result of experiments, the South African Reserve Bank (SARB) published a report stating that blockchain technology would significantly improve the speed and quality of the existing system. The investigations proved that the typical daily volume of the South African payments system could be processed in less than two hours with full confidentiality of transactions and settlement finality.

Other countries

Multiple countries are currently engaged in CBDC research and development. Other pioneers that launched the pilot include Jamaica, the United Arab Emirates, and Uruguay. Jamaica, for instance, has just launched its CBDC pilot in August 2021, and most probably, it will be followed by other governments in the upcoming years.

According to a 2021 Bank of International Settlements report, 86% of central banks are actively researching CBDCs, 60% have already done some experiments, while 14% have deployed pilot projects.

How are CBDCs and Diem connected?

Facebook-backed Diem has played a vital role in CBDC exploration.

The thing is that until 2019, when Diem (at that time, Libra) was announced, CBDCs were mainly neglected. Only a few countries started experimenting with national digital currencies earlier. Why so?

Facebook was one of the first global companies that openly talked about cryptocurrency adoption. And when it comes to such a powerful and widespread entity, this becomes a game-changer. 

Having heard of Facebook’s plans on launching Diem, governments accelerated CBDC exploration because it was the only technology capable of counterbalancing Diem’s influence. Yet, the mission of the Diem Association was never to take over the global payment system but rather to leverage the innovative approach of using distributed governance and complement existing currencies.

Still, CBDCs and Diem have many things in common.

First, both Diem and CBDCs can reach billions of people worldwide. This will help them grant financial inclusion to the unbanked population and provide digital identity.

Second, these technologies will significantly facilitate payment processes, enabling lower fees and faster transactions. 

Third, as any centralized currency, Diem is subject to regulation and overseen by one central entity - Diem Association that is made up of different companies like Uber, Shopify, Coinbase, Spotify, etc. Similarly, CBDCs are fully controlled by the national government of the country that issued them.

Fourth, they will enable worldwide access to stable currencies. For example, people from France, New Zealand, or any other corner of the world could have access to Diem’s stablecoin or the US digital dollar.

Fifth, CBDCs and Diem use similar infrastructure, making the most out of the blockchain technology that helps store and secure data. This is one more reason to believe that they represent the future of digital finance.

Diem future alongside CBDCs

Diem Association has clearly stated that they aim to complement existing fiat currencies and not replace them. To avoid any interference with national currencies and monetary policies of different countries, the Association introduced single-currency stablecoins, such as DiemUSD, DiemEUR, etc. and a multicurrency stablecoin. 

Diem multicurrency stablecoin will “consist of at least 80 percent very short-term (up to three months’ remaining maturity) government securities issued by sovereigns that have very low credit risk (e.g., A+ rating from S&P and A1 from Moody’s, or higher) and whose securities trade in highly liquid secondary markets. The remaining 20 percent will be held in cash, with overnight sweeps into money market funds that invest in short-term (up to one year’s remaining maturity) government securities with the same risk and liquidity profiles."‍

The added benefit of such an approach is a more smooth transition from cash and fiat money to digital currencies, leading to easier CBDC adoption.

“Diem has committed to fading out, for example, Diem dollar, if there were such a thing as a digital dollar issued by the Fed,” said Christian Catalini, the chief economist of Diem, speaking at Consensus 2021. “The public sector has a large comparative advantage in developing anything that has to do with stability, money, value preservation and macroprudential policy. We don’t want to change that. In fact, we want to build on and take advantage of that infrastructure to accelerate use cases for consumers both domestically and also globally.”

This year, the Diem team has progressed dramatically compared to previous development. Recently, they have partnered with Silvergate Bank and moved all the "primary operations" from Switzerland to the US. This will make launching a US dollar-pegged stablecoin easier.

According to the terms of the partnership, Diem will run the Diem Payments Network (DPN), a permissioned network that will only allow approved participants to

transact. Meanwhile, Silvergate will issue the Diem stablecoin and manage the reserve backing the token.

This partnership is one of the final steps before the Diem pilot launch, which is supposed to happen by the end of the year. At first, the token will be launched as a part of a small test project with limited transactions for individual users. Yet, as soon as the test is successfully over, the Diem team is expected to roll out the token with full functionality.

Conclusion

CBDCs are the next step in the evolution of money and how we perceive them. Over 70 countries worldwide have already started experimenting with central bank digital currencies, which will eventually lead to their mass adoption.

Facebook-backed Diem is another digital currency that will become available soon. It is believed to become a perfect interim asset that will facilitate CBDC development and introduce the world of digital finance to a general audience.

Diem stablecoins will certainly add value to the whole world of decentralized finance and attract billions of new users. To help them get a better understanding of Diem and facilitate the transition to the world of DeFi, we’ve created Pontem Network. 

Pontem Network is a Substrate-based Move VM Proof of Stake bridge to the Diem Blockchain that will enable creating DApps with no coding skills. This way, anyone will have a chance to build their own DApp, test it, and transfer it to Diem.

Stay tuned to find out more about Pontem Network and the world of DeFi!

Disclaimer: Pontem is not affiliated, associated, authorized, endorsed by, or in any way officially connected with Facebook, the Diem Association or any of its subsidiaries or its affiliates. All product and company names are trademarks™ or registered® trademarks of their respective holders.

If you’d like to learn more about DeFi and Pontem Network, join our official Telegram channel. And stay tuned to learn about our upcoming updates!