Central Bank Digital Currency (CBDC)
As digital tokens, central bank digital currencies are issued by central banks, just like cryptocurrency. Fiat currencies are pegged to the value of their countries’ fiat currencies.
Several countries are implementing CBDCs into their financial systems, and others are developing them. It is essential to understand what digital currencies are and what they mean to society since so many countries are researching ways to adopt them.
Key Points
- The digital version of a fiat currency issued by a central bank is the digital equivalent of its physical counterpart.
- A Central Bank Development Corporation (CBDC) is issued and regulated by the central bank or monetary authority of a nation.
- Introducing Central Bank Development Companies (CBDCs) will improve financial inclusion and simplify monetary and fiscal policy implementation.
- In contrast to some cryptocurrencies, centralized currencies may not provide anonymity to transactions.
- CBDCs are being investigated in numerous countries to see how they affect their economies, existing financial networks, and economic stability.
Understanding Central Bank Digital Currencies (CBDCs)
In other words, fiat money is money issued by the government of a country. Banknotes and coins have historically been used for this purpose. This is recognized as a form of legal tender in exchange for goods and services. Technology has allowed governments and financial institutions to move from a fiat money system based on physical money to a credit-based fiat system, where balances and transactions are recorded digitally.
Despite the continued exchange and acceptance of physical currency, its use in some developed countries has diminished significantly. A pandemic of COVID-19 has further contributed to the shift toward digital payments.
Digital currencies and cashless societies have been made more appealing by introducing and developing cryptocurrencies and blockchain technology. Therefore, the use of government-backed digital money is being explored by governments and central banks around the world. If and when these currencies are ever implemented, they will be backed and endorsed by the government that issued them, just like fiat currency.
Goals of Central Bank Digital Currencies
Many people in the U.S. and many other countries cannot access financial services. In an average household in the United States, over 5% of households don’t use a bank. Approximately 20% of American families have bank accounts but use expensive services such as money orders, payday loans, and check to cash.
The primary goals of CBDCs are to offer privacy, convenience, accessibility, and financial security to businesses and consumers. They also provide those who currently use alternative money transfer methods with lower-cost alternatives, decrease the maintenance costs of a complex economic system, and reduce cross-border transaction charges.
Note: Also, a CBDC provides the central bank of a country with the means of implementing monetary policies to stabilize the economy, control growth, and regulate inflation.
Using digital currencies issued by central banks, the risks associated with their current use would also be reduced. Cryptocurrencies have extremely volatile values, as they constantly fluctuate in value. Households may experience severe financial stress due to this volatility, which may impact the stability of an economy. CBDCs would offer strength and affordability to consumers, businesses, and households by backing them with a government and controlling them.
Types of CBDCs
Retail CBDCs and wholesale CBDCs are two types of CBDCs. Banks and financial institutions use wholesale CBDCs most often. The use of retail CBCDs is similar to a physical currency in that consumers and businesses use it.
Wholesale CBDCs
It is comparable to having reserve funds in a central bank to hold wholesale CBDCs. The central bank provides an institution with a bank account to place funds or settles interbank transfers. Reserve requirements and interest on reserve balances are other tools that central banks can use to set lending rates and influence lending.
Retail CBDCs
The retail CBDC is similar to the government-backed digital currency reserved for organizations. Those are the same services provided to consumers and businesses by the government. It eliminates the intermediary risk for retail banks, which means fewer customers’ assets will be lost in the event of bank failure. CBDCs can be divided into two categories: retail and wholesale, based on the access they provide.
- The CBDCs are transferred to the recipient using a pseudonymous digital wallet, allowing them to access cash-based services.
- Access provided by a bank account is similar to account-based access.
Note: Both types of CBDCs have their advantages and disadvantages. Thus, it is possible to combine the two and function in the same economic system.
Issues CBDCs Address and Create
In a recent report, the Federal Reserve summarized issues that a CBDC deals with and issues that a CBDC needs to address before being successfully designed and implemented.
Issues Addressed by CBDCs
- Risk-free for credit and liquidity
- Promotes the dollar’s relevance
- For inclusion in the financial system
- Improvement of cross-border payments
- It makes it more accessible to the general public
Issues That Need Addressing
- Protection and privacy
- regarding cybersecurity
- Influences monetary policy
- Stability of the financial system
- Structure changes in the financial sector
Issues a CBDC Addresses Explained
- It allows the unbanked population to gain access to financial services without adding high costs to the nation’s economic structure.
- The CBDC eliminates the risk of non-bank third parties experiencing events such as bank failures and bank runs. If any residual dangers still exist, they are the central bank’s responsibility.
- Using these companies, central banks can connect directly with consumers, eliminating costly infrastructure.
- Governments can cooperate more closely across borders to reduce cross-border transaction costs. Complex distribution systems can be simplified and reduced across borders.
- Despite the recent devaluation, the dollar remains the most used currency in the world5. A U.S. CBDC would enhance support and ensure its position.
Issues a CBDC Creates Explained
- There is a possibility that the U.S. financial structure will dramatically change. Uncertainty surrounds how a change in the financial system would affect household expenses, investments, banking, interest rates, and the economy.
- There is no way to tell what effects switching to CBDC will have on the stability of a financial system. If there are financial difficulties, there may not be enough liquidity at the central bank to facilitate withdrawals.
- Money supply and demand are determined by a monetary policy implemented by central banks to influence inflation, interest rates, lending, and spending, thereby affecting job creation. In order for central banks to positively impact the economy, they need to equip themselves with the necessary tools.
- The privacy of cryptocurrency is one of the biggest reasons behind its development. Monitoring is crucial since it enables authorities to fight money laundering and terrorism financing. The authorities would have to foot the bill to monitor for financial crimes against CBDCs.
- Cryptocurrencies have been repeatedly targeted by hackers and thieves, as evidenced on several occasions. The same crowd of thieves would likely target a central bank-issued digital currency, so significant efforts would need to be made to prevent the theft of assets and information.
CBDCs vs. Cryptocurrencies
Ecosystems based on cryptography offer a glimpse at an alternate currency system in which cumbersome regulations do not dictate each transaction’s terms. Consensus mechanisms protect them against tampering, making them hard to duplicate or counterfeit. They may not require blockchain technology or consensus mechanisms, but central bank digital currencies may be similar to cryptocurrencies.
In addition, cryptocurrencies are decentralized and unregulated. Investor sentiment, usage, and user interest determine the value of cryptocurrencies. Unlike stable assets, these assets are more suited to speculation, making them unlikely to be used in a financial system that demands stability. The market value of CDCs mirrors fiat currency, and they are designed for safety and stability.
Central Bank Digital Currencies at a Glance
The central banks of many countries have pilot programs and research projects to test whether a CBDC can be used effectively in their economies. According to the CBDCs launched as of February 2022, nine countries have done so.
- Grenada
- Nigeria
- Monserrat
- Dominica
- Saint Lucia
- The Bahamas
- Antigua and Barbuda
- Kitts and Nevis
- St Vincent and the Grenadines
CBDC initiatives and projects are being implemented in 78 other countries. A few examples are listed below:
- Jamaica introduced a CBDC in August 2021. The programme was successfully concluded in December 2021.
- As part of its research on CDBC implementation, the Bank of Canada (BOC) continues to research this model.
- The Swedish central bank began creating an electronic version of the krona (called e-krona) after cash use declined.
- A digital rupee will be introduced by the end of 2023, according to an announcement by India’s central bank in February 2022.
- USA researchers are examining the potential for CBDCs to increase efficiency, lower costs, and improve the domestic payments system.
- Many countries, including Australia, South Africa, Indonesia, Brazil, Peru, Chile, Uruguay, Thailand, Venezuela, Singapore, and others, have high GDP per capita.
- A number of inquiries are being conducted by the Bank of England (BoE) regarding CBDC integration into its financial system.
Is CBDC a Cryptocurrency?
Digital currencies issued by central banks are based on the blockchain and cryptocurrencies. Citibank Deposit Certificates are backed by the government and are considered legal tender in places where they have been implemented.
What Is the U.S. CBDC?
CBDCs are currently being researched by the Federal Reserve and its branches for implementation into the U.S. financial system. The CBDC will cease to exist in the United States in February 2022.
Is CBDC Based on Blockchain?
Together with the Digital Currency Initiative at Michigan Institute of Technology, the Federal Reserve Bank of Boston is developing a CBDC model. The CBDC research includes distributed ledgers and consensus mechanisms; however, it is unknown how they will be used.