What is a central bank digital currency (CBDC)?

What is a central bank digital currency (CBDC)?

A central bank digital currency (CBDC) is a form of digital currency issued by a country’s central bank. It is similar to cryptocurrencies, except that its value is set by the central bank and is equivalent to the country’s fiat currency.

Many countries are developing CBDCs and some have even implemented them. As so many countries are researching ways to transition to digital currencies, it is important to understand what CBDCs are and what they mean for society.

Key points

• A central bank digital currency (CBDC) is the digital form of a country’s own fiat currency.
• A nation’s monetary authority, or central bank, issues a CBDC, which promotes financial inclusion and streamlines the implementation of monetary and fiscal policies.
• Many countries are exploring how CBDCs could impact their economies, financial networks and stability.
• It is important for people and nations to understand central bank digital currencies because some world economies are moving towards using them.

Understanding Central Bank Digital Currencies (CBDCs)

Fiat money is a government-issued currency that does not have any physical commodity like gold or silver to back it. It is considered a form of legal tender which can be exchanged for goods and services.

Traditionally, fiat money consists of notes and coins, but technology has allowed governments and financial institutions to integrate physical fiat money with a credit-based currency model that records balances and transactions digitally.

Physical currency is still widely traded and accepted. However, some developed countries have seen a decline in its use, and that trend has accelerated during the pandemic.

The introduction and evolution of cryptocurrency and blockchain technology have spurred further interest in cashless societies and digital currencies.

Governments and central banks around the world are exploring the possibility of using government-backed digital currencies. When and if they are implemented, these currencies will enjoy the full trust and support of the government that issues them, just as fiat money does.

Purpose of CBDCs

In the United States and many other countries, many people do not have access to financial services. In the United States alone, in 2023, 6% of adults did not have a bank account. In many other countries, the figures are much higher. With this in mind, the main purposes of CBDCs are:

• Providing businesses and consumers conducting financial transactions with privacy, portability, convenience, accessibility and financial security.
• Decrease the maintenance costs required by a complex financial system, reduce the costs of cross-border transactions and provide those who currently use alternative methods of transferring money with low-cost options.
• Reduce the risks of using digital currencies, or cryptocurrencies, in their current form. Cryptocurrencies are highly volatile, with their value constantly fluctuating. This volatility could cause severe financial strain in many families and impact the overall stability of an economy. CBDCs, backed by a government and controlled by a central bank, would give families, consumers and businesses a safe means to exchange digital currency.

A CBDC also provides a country’s central bank with the means to implement monetary policies aimed at ensuring stability, controlling growth and influencing inflation.

Types of CBDCs

There are two types of CBDC: wholesale and retail. Financial institutions are the primary users of wholesale CBDCs, while consumers and businesses use retail CBDCs.

Wholesale CBDC

Wholesale CBDCs work similarly to holding reserves in a central bank. The central bank grants an institution an account in which to deposit funds or to be used to settle interbank accounts transfers. Central banks can then use monetary policy tools, such as reserve requirements or interest on reserve balances, to set interest rates and influence lending.

Retail CBDC

Retail CBDCs are government-backed digital currencies used by consumers and businesses. Retail CBDCs eliminate middleman risk: the risk that private issuers of digital currency could go bankrupt and lose customer assets.

There are two types of retail CBDCs. They differ in how individual users access and use their currency:

• Token-based retail CBDCs are accessible with private keys, public keys, or both. This validation method allows users to perform transactions anonymously.
• Account-based retail CBDCs require digital identification to access an account.

It is possible to develop and implement the two types of CBDCs and make them work in the same economy.

Issues surrounding CBDCs

The Federal Reserve has identified the issues faced by CBDCs, as well as the issues that must be addressed before a CBDC can be designed and implemented.

Problems faced by CBDCs

• Free from credit and liquidity risk

• Reduction of costs of cross-border payments

• Support the international role of the dollar

• Aiming for financial inclusion

• Expand access to the general public

Problems created by CBDCs

• Changes in the financial structure

• Stability of the financial system

• Influence of monetary policy

• Privacy and protection

• Cyber ​​security

Problems faced by CBDCs

• Eliminate third-party risk of events such as bank failures or ran to the counters. Any residual risk that remains in the system rests with the central bank.
• It can reduce the high costs of cross-border transactions by reducing complex distribution systems and increasing jurisdictional cooperation between governments.
• It could support and protect the dominance of the US dollar; the US dollar is still the most used currency in the world.
• Eliminate the costs of implementing a financial structure within a country to ensure financial access to the unbanked population.
• It can establish a direct connection between consumers and central banks, thus eliminating the need for expensive infrastructure.

Problems created by CBDCs

• If the financial structure of the United States were to change dramatically, it is unknown how this would affect household spending, investments, bank reserves, interest ratesthe financial services sector or the economy.
• The move to a CBDC could have unknown effects on the stability of a financial system. For example, central bank liquidity may not be sufficient to facilitate withdrawals during a financial crisis.
• Central banks implement monetary policy to influence inflation, interest rates, lending, and spending, which in turn affect employment rates. Central banks must ensure that they have the necessary tools to have a positive impact on the economy.
• Privacy is one of the most important factors behind cryptocurrency. CBDCs would require adequate intrusion by authorities to monitor financial crimes; monitoring is also important because it supports efforts to combat money laundering and terrorist financing.
• Cryptocurrencies have been the target of hackers and thieves. A digital currency issued by a central bank would likely attract the same crowd of thieves. Therefore, efforts to prevent system penetration and theft of assets and information should be vigorous.

CBDC vs cryptocurrencies

The cryptocurrency ecosystem offers a glimpse of an alternative currency system where cumbersome regulations don’t dictate the terms of every transaction. Such transactions are difficult to duplicate either counterfeit and are guaranteed by consensus mechanisms that prevent tampering.

Central bank digital currencies are designed to be similar to cryptocurrenciesbut they may not require blockchain technology or consensus mechanisms.

Furthermore, cryptocurrencies are unregulated and decentralized. Their value is dictated by investor sentiments, usage and user interest. These are volatile assets best suited to speculation, making them unlikely candidates for use in a financial system that requires stability. CBDCs mirror the value of fiat currency and are designed to provide stability and security.

CBDC in use and in development

Central banks in many countries have launched pilot programs and research projects to determine the feasibility and usability of a CBDC in their economies.

As of March 2024, three countries had a functioning CBDC: Bahamas, Jamaica and Nigeria. The Eastern Caribbean Currency Union has discontinued its CBDC for technical reasons and has started a new pilot program.

There are 36 CBDC pilot projects in operation and 8 of the G20 have programs in development. The BRICS countries – Brazil, Russia, India, China and South Africa – are exploring a CBDC.

An example of a failed CBDC attempt is the UK Britcoinexisting between 2011 and 2019.

According to the Federal Reserve, the United States is one of those countries that is exploring whether a CBDC “could improve the already secure and efficient US domestic payments system.”

What is the purpose of a CBDC?

CBDCs are government-backed digital currencies that use blockchain or distributed ledger technology. Their aim is to expand accessibility to financial services and reduce the costs of maintaining current monetary systems.

Will the US transition to digital currency?

Not yet. The Federal Reserve and its subsidiaries are studying CBDCs and how to implement them in the U.S. financial system. President Joe Biden has ordered the development of a national strategy on digital currencies.

Has any country launched a CBDC?

Yes, Jamaica, Nigeria and the Bahamas have launched CBDCs.

Is CBDC a threat?

CBDCs should be implemented to enhance existing financial networks and fiat currencies, not replace them. If one were launched to replace a fiat currency, it could cause problems for the system, but no country has tried it yet, so the effects it could have are unknown or, at best, theoretical.

The bottom line

Many countries are researching or developing central bank digital currencies, and three have implemented them. The main purpose of a CBDC is to provide businesses and consumers with privacy, transferability, convenience, accessibility and financial security.

Many people around the world don’t have access to bank accounts, so a CBDC would give them the ability to get paid, keep their money and pay their bills. CBDCs could also reduce the maintenance required by a complex financial system, reduce the costs of cross-border transactions, and offer people using alternative methods of transferring money options at lower costs.

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