-It could shake the very foundation of how money circulates... and make Bitcoin matter even more

Interest is growing in the electronic money issued by central banks, the CBDC (Central Bank Digital Currency). China has been the most aggressive in developing one, and Brazil's central bank has said it plans to issue a CBDC before 2023 arrives. dGen, a German nonprofit think tank specializing in fintech, has predicted that three to five countries will completely replace their national currency with a CBDC within a decade. On that basis it warned that if Europe does not issue a CBDC, the value of the euro will be overtaken by China's yuan by 2025.

For Bitcoin investors, the prospect of a safe and certain cryptocurrency issued by a central bank looms large. That is because quite a few people, while acknowledging Bitcoin's technological innovation, expect that a government response such as a CBDC will drain Bitcoin of its reason for being. The argument is that once central banks roll out digital currencies to replace Bitcoin in earnest, Bitcoin is finished.

It is worth beginning with why discussion of CBDCs has surged recently. The Chinese government's aggressive moves are part of it, but above all the aftershocks of last year's Facebook Libra can be seen as the biggest factor. Philipp Sandner, head of the Blockchain Center at the Frankfurt School, criticized the European Central Bank (ECB) for being slow to respond on CBDCs, stressing that "given the Libra project and the digital yuan, the ECB must respond swiftly to defend its geopolitical position."

The shared view among the central bank elites who sit atop the financial pyramid has been that, however ingenious its technology, Bitcoin cannot function as money because its price is unstable. But a Libra issued by Facebook is a different story. Its price would be stable, and it would have no borders. On top of that, there was the possibility that a staggering population of two billion users would be bound together into a Libra currency zone. They could not help but feel a sense of crisis that tech companies, which had already secured technological and commercial superiority in the means of payment, would in effect come to occupy the summit of the financial pyramid.

Amid this mood, many central banks -- including the Bank of Korea -- have announced one after another that they will study CBDCs, and yet even the conceptual definition of a CBDC is not clear. The International Monetary Fund (IMF) stated in a recent report that there is no single technology that characterizes a CBDC. Contrary to the hopes of Bitcoin skeptics, it does not even appear that CBDCs will make use of blockchain. The reason is that central banks feel no need to take on blockchain's open and transparent character. Push a step further and the reality is that no clear answer has been produced even for why a CBDC should be introduced at all.

The Reserve Bank of Australia (RBA) argued in a report that the need for a CBDC is not great. It noted that Australia already has efficient infrastructure such as the New Payments Platform, which enables real-time interbank settlement; that although overall cash use is declining, the pace of decline is not rapid; and that during the COVID-19 pandemic, demand for cash within Australia actually increased.

The RBA also examined the negative effects of a CBDC. Australian banks fund roughly 60% of their money through deposits; if a CBDC were issued and deposits shrank, banks' funding costs would rise, and the cost of financial products would inevitably increase.

Whatever the technical features of a CBDC and whatever its conceptual definition, introducing one does not look easy. That is because a CBDC could fundamentally upend the existing structure through which money circulates -- a structure made up of the central bank, commercial banks, corporations and the private sector. As the RBA warned, there is a strong likelihood that a CBDC would erode the very basis on which commercial banks exist.

The private sector's stock of cash sits in wallets, in dresser drawers, or in bank vaults. Money placed in a bank expands credit; cash held in a wallet or a drawer does not. A central bank's CBDC leaves a balance on a smartphone, so it creates no credit. Carry the imagination to its extreme and, because of the CBDC, banks would have to lend out of long-term savings alone. Long-term savings require paying that much more interest, which means the cheap source of credit creation disappears.

The base money issued by a central bank consists of cash and reserves. Reserves are the savings commercial banks keep at the central bank, while cash is the money dispersed into the private sector. Both cash and reserves are liabilities of the central bank, but cash creates no credit, whereas reserves create credit and thereby increase the money supply. Reserves are assets that commercial banks are obliged to deposit at the central bank. Commercial banks lend out the deposits left after reserves and earn interest income. They do not let short-term deposits sit idle but put them to work in long-term loans. This is possible because, even with demand deposits, depositors do not all withdraw at the same time. When the central bank raises the reserve requirement ratio, commercial banks' lending activity is restrained and the money supply in the market shrinks.

But if the central bank issues cash in electronic form and provides it directly to the non-bank public, the share of cash within the base money rises. The money multiplier -- the ratio by which the money supply increases as bank deposits repeatedly create credit -- starts from the premise that individuals and businesses place their cash in bank vaults. They do so because using the financial system makes payment, remittance and storage easier than carrying cash around. A CBDC, however, is a scheme in which central-bank-issued electronic money moves from one individual's smartphone to another's. There is no need to pass through the banking network.

For this reason, a two-tier CBDC is under consideration. The idea is that the central bank does not deal with the public directly but distributes the CBDC through the commercial banks.

In that case, there would be no structural difference from the existing debit card system. Debit cards were already being called electronic money before Bitcoin appeared. When the public makes a payment using an electronic means of payment, the bank's ledger is adjusted at the same time. The payer's balance falls and the recipient's balance rises. For this reason, experts such as Qu Qiang, a professor at Renmin University of China, argue that China's two-tier-oriented CBDC is no different from Alipay or WeChat. In fact, China does not call it a CBDC but DCEP (Digital Currency Electronic Payment). It does not emphasize central bank issuance.

In the CBDC Era, Credit Creation Will Be Done by "Programs"

A central bank finds it hard to betray the commercial banks. One must also weigh the historical path by which the central bank was established as an institution to rescue commercial banks from failure (bank runs). Finance, in other words, is a system that the entire network centered on commercial banks collectively brings into being. If a central bank were to ignore the commercial banks, issue a one-tier CBDC and distribute it directly to the public, the collapse of the commercial banks would accelerate. Their competitiveness had already been weakening amid the turbulent innovation brought on by the internet, smartphones and blockchain. The CBDC, meant to defend the banking sector's exclusive prerogatives against the private sector, would end up bringing about the banking sector's downfall -- or else its transformation.

In the CBDC era, credit creation is likely to be led not by banks but by programs. The foundation is a technology that statistically processes the average balance held on each individual's smartphone, determines how much of it can be put to work, and lends it to others without the owner even being aware. The original owner can use the balance at any time, so nothing is inconvenient, and interest is even paid on the balance, so the owner will consent to the contract. But a program of that sophistication could, even before creating credit, automatically hedge the swings in Bitcoin's price. That is to say, the ecosystem built for Bitcoin is also the ecosystem for a CBDC.

If we are entering an era in which a smartphone application, or the smartphone device itself, functions as a bank, then the winner of the game is unlikely to be the commercial bank.