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What is Central Bank Digital Currency (CBDC)?

UTC by Osaemezu Ogwu · 7 min read
What is Central Bank Digital Currency (CBDC)?
Photo: Depositphotos

While the number of countries exploring the concept of CBDC is actively growing, we invite you to learn the key basics of Central Bank Digital Currencies in this guide.

The adoption of cryptocurrency and blockchain technology has gained considerable momentum in the past few years, especially in 2020. The COVID-19 pandemic has harmed the traditional finance system of people towards cash-less options. The immense popularity of Bitcoin and the emergence of several Blockchain-backed projects like the announcement of Facebook’s Libra launch last year have made governments realize the importance of these regulation-free and decentralized financial systems and are protecting against these threats to the traditional banking and finance industry.

Despite being influenced by decentralized cryptocurrencies like Bitcoin, CBDC is more of a reaction to than an embrace of cryptocurrency, which central banks see more as a threat to be managed. These Central banks are implementing the concept of stablecoins to have in-depth knowledge of the cryptocurrency space to develop their version of digital currency that will be regulated and operated by the respective monetary authorities or central banks of a particular country.

What is CBDC?

Central Bank Digital Currency (CBDC) is the digital form of the fiat money of a country. The present concept of CBDC utilizes the concept of blockchain and distributed ledger technology like cryptocurrencies. Still, CBDC is different from virtual currency and cryptocurrency because the latter is decentralized, i.e., they are not issued by the state and lack the legal tender status declared by the government.

The creation of CBDC is to fuse the best of both worlds – the convenience and security of digital form like cryptocurrencies, and the regulated, reserved-backed money circulation of the traditional banking system. Each CBDC unit will act as a secure digital equivalent of fiat currency and can be used as a payment mode, a store of value, and a unit of account. As a fiat currency with a unique serial number, each CBDC unit will also be distinguishable to prevent imitation. Since it will be a part of the central bank’s money supply, it will work alongside other forms of fiat currencies.

There are two main types of CBDC, Wholesale and Retail CBDC, and both have distinct purposes.

Wholesale CBDC is the digital currency used in a transaction between the central bank and other private banks. It could also be used for cross-border transactions between banks. An example is the project Inthanon – Lionrock, a cross-border digital payment system between the Bank of Thailand and Hong – Kong Central Bank.

Retail CBDC is the digital money that individuals would use to conduct transactions in day-to-day life. Retail CBDC could render cash obsolete, and it would also be traceable, thereby mitigating various criminal activities.

Benefits of CBDC

The finance system is always dynamic due to the introduction of new technology now and then in the sector, and the advent of digital currency is no different. Some of the advantages of the adoption of CBDC are;

  • CBDC could improve the productivity and safety of both retail and wholesale payment solutions. These improvements range from retail providers using a point of sale, online, or P2P solutions to wholesale interbank payments with faster settlement options.
  • With cryptocurrency driving the world into a cashless society, the introduction of CBDC helps ease the transition from fiat currency to digital options with the presence of a regulatory body against illicit activities.
  • The introduction of government-backed digital currency will aid in making cross-border digital transactions between parties fast and seamless.
  • Physical cash has seen a significant decline in recent years, especially this year, as more consumers use cards and payment settlement applications. Suppose a CBDC were to be issued and recognized as legal tender. In that case, the decreased use of cash could help alleviate some of the negative use cases for cash (tax evasion, money laundering, illegal transactions, etc.
  • The introduction of CBDC helps prevent criminal activity such as money laundering, tax evasion or avoidance, and other activities by tracking and observing the flow of money.

Risks Associated with Central Bank Digital Currencies

The most often referenced disadvantage is the disintermediation of commercial banks if consumers start to adopt CBDC fully. This could create a vicious cycle as banks raise deposit rates to attract more money. In turn, this means less bank credit extended at higher interest rates.

There are also doubts raised over CBDC requiring the central bank to undertake KYC/AML processes and other operational burdens that commercial banks usually handle.

There is also the issue of reputational risk as CBDC could suffer cyber-attacks, different kinds of error, and glitches that might adversely affect the central bank’s reputation.

Although Central Bank Digital Currency has the potential advantages for cross border transactions, CBDC nevertheless might endanger economies with high inflation and volatile exchange ranges due to the risk of dollarization.

Where CBDC Stands Today?

Several central banks are exploring the feasibility of digital currency adoption, and most are in the research phase, and some still in the planning phase. The progress of the central bank of some countries is listed below:

China

The Asian country with a population of over 1 billion is a suitable testing ground for implementing cryptocurrency; China is arguably the leading country in terms of digital currency adoption. The project for the development of the new digital currency started early this year. As of now, it was reported that it had passed the first stage of testing where RMB 1.1 billion ($162 million) was processed across 3.1 million digital Yuan transactions between April and August, making it the most widely used CBDC in a commercial setting.

Sweden

The country has long been interested in CBDC and was one of the early testers for digital currency implementation. Early this year began the launch of a year-long pilot project of its proposed digital currency, e-krona. The Swedish government believes that in 2023, the adoption of its digital currency will be successful, and retailers would begin to use it for transactions.

Uruguay

Uruguay’s central bank ran a successful pilot program for its digital currency e-peso in 2017, heralded by top financial institutions. Still, no large-scale implementation has been announced since then.

Thailand

The Bank of Thailand (BOT) has completed the second testing phase of its CBDC called Project Inthanon. The project started in August last year. The first phase focused on developing a proof-of-concept decentralized Real-Time Gross Settlement system (RTGS) that uses a CBDC on a distributed ledger. The second phase, now complete, started in February to further explore how DLT can be used in the tokenization of BOT-issued debt instruments on DLT, and incorporation of regulatory compliance and data reconciliation functions into the payment process using DLT. The third phase is in progress and is due to be completed later in the year.

France

The European nation began the pilot program for what was touted as the first digital euro currency early this year and recorded success in the first phase of testing.

Conclusion

Blockchain-based technology has been on a relentless march towards integration with traditional finance systems. The fact that CBDC has become a viable option in finance is a testament to how much individuals and enterprises embrace technology.

There are a plethora of countries still exploring the concept of CBDC, including the United States. Central Banks are looking to integrate this new technology with the traditional monetary system to stay current with finance technology’s dynamism. The methods through which payments are made have drastically evolved over the last ten years and will continue to do so as new technology breakthroughs are made.

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