What Is the Difference Between Cryptocurrency and CBDCs?

What’s in today’s article?

• Why in news?
• What is cryptocurrency?
• Growth of crypto ecosystem presents new opportunities
• Challenges posed by crypto assets
• What is central bank digital currency (CBDC)?
• What is the difference between cryptocurrency and CBDCs?
• News Summary: IMF’s view on cryptocurrency in Latin America
• Why is Latin America’s crypto economy so significant?
• Why does El Salvador stand out among crypto economies?
• How did the IMF react to El Salvador’s Bitcoin adoption?

 

Why in news?

• Recently, the International Monetary Fund (IMF) issued a statement on the use of cryptocurrency in the Latin America and Caribbean market, and about the rising interest in blockchain-based central bank digital currencies (CBDCs).
• The IMF ended its statement noting that a ban on crypto “may not be effective in the long run” in the region.
• This has raised eyebrows due to the international organisation’s change in stance on crypto in the Latin American market.
  • Earlier, IMF had said that rapid growth and increasing adoption of crypto assets pose financial stability challenges as these are extremely volatile.
  • This was highlighted in the chapter titled The Crypto Ecosystem and Financial Stability Challenges published in Global Financial Stability Report 2021.

 

What is cryptocurrency?

• Cryptocurrencies are digital or virtual currencies in which encryption techniques are used to regulate the generation of their units and verify the transfer of funds,
• These currencies operate independently of a central bank.

 

Growth of crypto ecosystem presents new opportunities

• Technological innovation is ushering in a new era that makes payments and other financial services cheaper, faster, more accessible.
  • It allows these services to flow across borders swiftly.
• Bank deposits can be transformed to stable coins that allow instant access to a vast array of financial products and allow instant currency conversion.
• Decentralised finance could become a platform for more innovative, inclusive, and transparent financial services.

 

Challenges posed by crypto assets

• The rapid growth and increasing adoption of crypto assets also pose financial stability challenges as these are extremely volatile.
• These are much more volatile than equities or commodities or even exchange rates. This volatility is introducing instability in the ecosystem.
• Challenges posed by the crypto ecosystem include
  • operational and financial integrity risks from crypto asset providers,
  • investor protection risks for crypto-assets,
  • inadequate reserves and disclosure for some stable coins.

 

What is central bank digital currency (CBDC)?

• CBDCs are digital currencies issued by central banks. Their value is linked to the issuing country’s official currency.
• In other words, CBDCs are the legal tender issued by a central bank in a digital form.
  • The digital rupee (e-Rupee) is the digital currency launched by Reserve Bank of India.
• It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency, only its form is different.
• CBDCs are similar to—but not the same as—stablecoins.
  • Stablecoins are a specific type of private, stabilized cryptocurrency pegged to another currency, commodity, or financial instrument with the goal of maintaining a relatively stable value over time.

 

What is the difference between cryptocurrency and CBDCs?

• Role of central bank
  • Cryptocurrencies and CBDCs are both blockchain-based digital currencies.
  • However, cryptocurrencies are generally run by private companies or individuals.
  • On the other hand, a CBDC is controlled and tracked by a country’s central bank and corresponds to that country’s fiat currency.
• Volatility
  • Bitcoin’s price may vary by hundreds or even thousands of dollars in a short period of time.
  • On the other hand, a CBDC would (ideally) be worth as much as its physical counterpart.
• Investment vehicles
  • Investors often buy large quantities of Bitcoin or other cryptocurrencies and hold them in the hope of making a profit.
  • This doesn’t make sense in the case of CBDCs as they are not meant to be investment vehicles.

 

News Summary: IMF’s view on cryptocurrency in Latin America

Why is Latin America’s crypto economy so significant?

• Countries like Argentina, Chile, and Columbia have experienced devaluation of their currency against the U.S. dollar.
• To preserve the value of their savings, some residents have explored converting their funds to U.S. dollars. However, there are legal restrictions controlling this.
• Others have chosen to convert their assets to stablecoins - cryptocurrencies designed to reflect the value of fiat currencies such as the U.S dollar.
• A number of central banks in the Latin American market are also considering CBDCs, meaning that more people could soon be exposed to blockchain-based infrastructure.

 

Why does El Salvador stand out among crypto economies?

• El Salvador is the first country in the world to adopt Bitcoin - the largest cryptocurrency by market capitalisation - as its legal tender.
• El Salvador uses a digital wallet known as Chivo to regulate users’ crypto transactions.

 

How did the IMF react to El Salvador’s Bitcoin adoption?

• The IMF said it was against El Salvador’s move, citing fiscal risks and consumer protection issues.
• This is why IMF’s latest blog post on crypto and CBDC use in Latin America and the Caribbean came as a surprise to many.
  • The post said that while a few countries have completely banned crypto assets given their risks, this approach may not be effective in the long run.
  • It called for regulation of cryptocurrency and recording crypto transactions for transparency.

 

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Q1) What is Latin America?

Latin America refers to a region in the Americas that is primarily composed of countries in Central and South America, as well as some Caribbean islands. The term "Latin" in Latin America refers to the languages spoken in the region, which are primarily derived from Latin, such as Spanish, Portuguese, and French.

 

Q2) What is IMF? 

The IMF stands for the International Monetary Fund. It is an international financial institution that was established in 1944 with the goal of promoting global monetary cooperation, financial stability, and sustainable economic growth.

 

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Source: Explained | IMF’s view on cryptocurrency in Latin America | IMF | Mckinsey