What Is a Central Bank Digital Currency (CBDC)?

What Is a Central Bank Digital Currency (CBDC)?

The term central bank digital currency (CBDC) refers to the virtual form of a fiat currency. A CBDC is an electronic record or digital token of a country’s official currency. As such, it is issued and regulated by the nation’s monetary authority or central bank. As such, they are backed by the full faith and credit of the issuing government. CBDCs can simplify the implementation of monetary and fiscal policy and promote financial inclusion in an economy by bringing the unbanked into the financial system. Because they are a centralized form of currency, they may erode the privacy of citizens. CBDCs are in various stages of development around the world.

How Central Bank Digital Currencies (CBDCs) Work

Fiat money is the term that refers to currency issued by a country’s government. It comes in the form of banknotes and coins. It is considered a form of legal tender that can be used for the sale and purchase of goods and services along with kinds of transactions. A central bank digital currency is the virtual form of fiat money. As such, it has the full faith and backing of the issuing government, just like fiat money does.

CBDCs are meant to represent fiat currency. The goal is to provide users with convenience and security of digital as well as the regulated, reserve-backed circulation of the traditional banking system. They are designed to function as a unit of account, store of value, and medium of exchange for daily transactions. CBDCs will be backed by the full faith of the issuing government—just like fiat currency. Central banks or monetary authorities will be solely liable for their operations.

There were 83 countries around the world pursuing CBDC development as of October 2021. Their reasons for pursuing this venture varied. For example:

• Sweden’s Riksbank began developing an electronic version of the krona (called e-krona) after the country experienced a decline in the use of cash.
• The United States wants to introduce CBDCs in its monetary system to improve the domestic payments system.

Developing countries may have other reasons. For instance, a significant number of people in India are unbanked. Setting up the physical infrastructure to bring the unbanked into the financial ecosystem is costly. But establishing a CBDC can promote financial inclusion in the country’s economy.

Types of CBDCs

There are two types of CBDCs: Wholesale and retail central bank digital currencies. We’ve listed some of the main features of each below.

Wholesale CBDCs

Wholesale CBDCs use the existing tier of banking and financial institutions to conduct and settle transactions. These types of CBDCs are just like traditional central bank reserves.

One type of wholesale CBDC transaction is the interbank payment. It involves the transfer of assets or money between two banks and is subject to certain conditions. This transfer comes with considerable counterparty risk, which can be magnified in a real-time gross settlement (RTGS) payment system.

A digital currency’s ledger-based system enables the setting of conditions, so a transfer won’t occur if these conditions are not satisfied. Wholesale CBDCs can also expedite and automate the process for cross-border transfers.

Current real-time settlement systems mostly work in single jurisdictions or with a single currency. The distributed ledger technology (DLT) available in wholesale CBDCs can extend the concept to cross-border transfers and expedite the process to transfer money across borders.

Retail CBDCs

Wholesale CBDCs improve upon a system of transfers between banks. Retail CBDCs, on the other hand, involve the transfer of central government-backed digital currency directly to consumers. They eliminate the intermediary risk or the risk that banking institutions might become illiquid and sink depositor funds.

There are two possible variants of retail CBDCs are possible, depending on the type of access they provide:

• Value- or cash-based access: This system involves CBDCs that are passed onto the recipient through a pseudonymous digital wallet. The wallet will be identifiable on a public blockchain and, much like cash transactions, will be difficult to identify parties in such transactions. According to Riksbank, the development of a value- or cash-based access system is easier and quicker compared to token-based access.
• Token- or account-based access: This is similar to the access provided by a bank account. Thus, an intermediary will be responsible for verifying the identity of the recipient and monitoring illicit activity and payments between accounts. It provides for more privacy. Personal transaction data is shielded from commercial parties and public authorities through a private authentication process.

Advantages and Disadvantages of CBDCs

Advantages

CBDCs simplify the process of implementing monetary policy and government functions. They automate the process between banks through wholesale CBDCs and establish a direct connection between consumers and central banks through retail CBDCs. These digital currencies can also minimize the effort and processes for other government functions, such as distribution of benefits or calculation and collection of taxes.

Disbursement of money through intermediaries introduces third-party risk to the process. What if the bank runs out of cash deposits? What if there is a bank run due to a rumor or an external event? Events like these have the potential to upset the delicate balance of a monetary system. A CBDC eliminates third-party risk. Any residual risk that remains in the system rests with the central bank.

It is possible to calibrate privacy features in a CBDC system. A value-based retail CBDC functions like cash and preserves privacy by making transactions pseudonymous. On the other hand, account-based access to CBDCs functions like a regular bank account and can be equipped with privacy features.

One of the roadblocks to financial inclusion for large parts of the unbanked population, especially in developing and poor countries, is the cost associated with developing the banking infrastructure needed to provide them with access to the financial system. CBDCs can establish a direct connection between consumers and central banks, thus eliminating the need for expensive infrastructure.

CBDCs can prevent illicit activity because they exist in a digital format and do not require serial numbers for tracking. Cryptography and a public ledger make it easy for a central bank to track money throughout its jurisdiction, thereby preventing illicit activity and illegal transactions using CBDCs.

Disadvantages

CBDCs don’t necessarily solve the problem of centralization. A central authority (the central bank) is still responsible for and invested with the authority to conduct transactions. Therefore, it still controls data and the levers of transactions between citizens and banks.

Users would have to give up some degree of privacy since the administrator is responsible to collect and disseminate digital identifications. The provider would become privy to every transaction conducted. This can lead to privacy issues, similar to the ones that plague tech behemoths and internet service providers (ISPs). For example, criminals could hack and misuse information, or central banks could disallow transactions between citizens.

The legal and regulatory issues pertaining to CBDCs are a black hole. What will be the role of these currencies and who will regulate them? Considering their benefits in cross-border transfers, should they be regulated across borders? Experiments in CBDCs are ongoing, and this could translate to a long-term frame.

The portability of these systems means that a strong CBDC issued by a foreign country could end up substituting a weaker country’s currency. A digital U.S. dollar could substitute the local currency of a smaller country or a failing state. Let’s look at Ecuador, which replaced its official currency (the sucre) with the U.S. dollar in 2000 after high inflation forced citizens to convert their money to U.S. dollars.

CBDCs vs. Cryptocurrencies

The idea for central bank digital currencies owes its origins to the introduction of cryptocurrencies which are digital currencies secured by cryptography. This makes them hard to duplicate or counterfeit. They are decentralized networks that are based on blockchain technology. The invention of a secure and immutable ledger allows transactions to be tracked. It also enables seamless and direct transfers, without intermediaries and between recipients simplifies the implementation of monetary policy in an economy.

The cryptocurrency ecosystem also provides a glimpse of an alternate currency system in which cumbersome regulation does not dictate the terms of each transaction. Established in 2009, Bitcoin is one of the world’s most popular cryptocurrencies. No physical coins actually trade hands. Instead, transactions are traded and recorded on a public, encrypted ledger, which can be accessed by anyone. The process of mining allows all transactions to be verified. No governments or banks back Bitcoin.

Though the current cryptocurrency ecosystem does not pose a threat to the existing financial infrastructure, it has the potential to disrupt and simplify the existing system. Some experts believe the moves by central banks to design and develop their own digital currencies will act as a measure to pre-empt such an eventuality.

Examples of CBDCs

Central-bank-backed digital currencies haven’t been formally established yet. Many central banks have pilot programs and research projects in place that are aimed at determining the viability and usability of a CBDC in their economy. China is the furthest along this route, having already laid down the groundwork and initiated a pilot project for the introduction of a digital yuan.

Russia’s plan to create the CryptoRuble was announced by Vladimir Putin in 2017. Speculators suggest that one of the main reasons for Putin’s interest in blockchain is that transactions are encrypted, making it easier to discreetly send money without worrying about sanctions placed on the country by the international community.

A number of other central banks have been researching the implementation of a CBDC, including:

• Sweden’s Riksbank, which began exploring the issuance of a digital currency in its economy in 2017 and has published a series of papers exploring the topic.
• The Bank of England (BoE), which is among the pioneers to initiate the CBDC proposal.
• The Bank of Canada (BOC).
• The central banks of Uruguay, Thailand, Venezuela, and Singapore.