What Is Central Bank Digital Currency (CBDC)?

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by John Caroline · 8 min read
What Is Central Bank Digital Currency (CBDC)?
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Since the number of countries exploring the concept of CBDC is actively growing and their adoption is expanding, it is important to understand how this works and how one can leverage CBDCs to improve one’s financial stability. We invite you to learn the key basics of Central Bank Digital Currencies in this guide.

In recent years, there has been a growing interest in the concept of Central Bank Digital Currency (CBDC) as an evolution of traditional currency. Since the emergence of blockchain technology, Bitcoin (BTC) and other cryptocurrencies have gained traction, prompting governments to recognize the significance of these decentralized financial systems. Besides, back in 2020, the COVID-19 pandemic harmed the traditional finance system in favor of cashless options. In response, central banks started exploring CBDCs as a regulated alternative to cryptocurrencies. They view CBDCs as a way to manage the potential threats posed by cryptocurrencies.

Unlike traditional cash or physical currency, CBDC exists purely in digital form and operates on distributed ledger technology. This guide aims to provide a comprehensive overview of CBDC, its functionalities, benefits, and potential challenges.

What Is a Central Bank Digital Currency (CBDC)?

A Central Bank Digital Currency (CBDC) is a digital representation of a nation’s fiat currency issued and regulated by its central bank. The CBDC is designed to offer a secure, accessible, and efficient form of money for both businesses and individuals.

Unlike decentralized cryptocurrencies, CBDC is regulated and backed by the government. It aims to combine the convenience and security of digital currencies with the stability and regulation of traditional banking systems. Each CBDC unit acts as a secure digital equivalent of fiat currency and can be used for payments, storing value, and accounting.

There are two types of CBDCs: wholesale CBDC for transactions between central and private banks and retail CBDC for everyday transactions among individuals. Retail CBDC has the potential to replace cash and can help track and reduce criminal activities.

Notably, the retail form of CBDC is available to the general public and acts as a digital replacement for physical cash. It is meant to be widely accessible and usable for day-to-day transactions. The wholesale CBDC, on the other hand, is reserved for financial institutions and is primarily used for large-scale interbank transactions and settlements.

It is important to note that CBDCs have been proposed with several key goals in mind, some of which include the following:

  1. Payment efficiency. CBDCs aim to improve the speed and efficiency of cross-border transactions, reducing settlement times and lowering transaction costs.
  2. Security and transparency. By leveraging blockchain or distributed ledger technology, CBDCs can enhance security and ensure transparent transactions, reducing the risk of fraud and counterfeiting.
  3. Monetary policy implementation. CBDCs can enable central banks to implement more precise and effective monetary policies, as they have better visibility into the flow of money within the economy.

The underlying technology of CBDCs can vary, but they are typically built on distributed ledger technology. Each unit of CBDC represents a specific amount of the nation’s fiat currency and is recorded on the digital ledger. When a user wants to make a transaction, they send CBDC from their digital wallet to the recipient’s wallet, which is recorded and verified on the decentralized network.

Types of CBDCs

Central Bank Digital Currencies come in various forms, each being piloted in different countries. One type is the account-based model, an example of this is DCash in the Eastern Caribbean, where consumers hold deposit accounts directly with the central bank.

Furthermore, the European Central Bank is considering a model where licensed financial institutions operate permission nodes of the blockchain network for a digital euro distribution.

Lastly, a model favored by “cryptophiles” involves issuing fiat currency as anonymous fungible tokens to protect users’ privacy, although it’s not yet fully tested by central banks.

Some of the models that have been mostly adopted by many countries using CBDCs include the following:

  • Account-based CBDC. In this model, individuals and businesses have accounts directly with the central bank, similar to commercial bank accounts. Transactions are recorded in these accounts, and users can access their CBDC through digital wallets.
  • Token-based CBDC. Token-based CBDCs use digital tokens that are not directly linked to individual accounts. These tokens can be transferred peer-to-peer or through third-party payment providers.

CBDCs vs. Cryptocurrencies

Although CBDCs and cryptocurrencies share some similarities, they have proven to differ in some areas fundamentally. In terms of their central basis, CBDCs are issued and regulated by central banks, while cryptocurrencies are decentralized and not tied to any central authority.

Moreso, CBDCs are usually designed to maintain a stable value, similar to traditional fiat currencies. In contrast, cryptocurrencies like Bitcoin can experience significant price volatility.

Lastly, CBDCs are generally considered legal tender within their respective countries, while cryptocurrencies may not be accepted as such.

Benefits of CBDCs

Central banks and governments worldwide are exploring the implementation of CBDCs due to several potential benefits it poses to the economy. One of the notable benefits of CBDCs is that it brings banking services to underserved populations, promoting economic growth. Basically, CBDCs enhance financial inclusion by providing access to banking services for the unbanked and underbanked populations. As such, individuals without traditional bank accounts can still participate in the digital economy.

Furthermore, CBDCs could reduce transaction costs associated with cash handling and processing while helping central banks gain real-time insights into money flows, enabling more effective monetary policy implementation.

It is also important to note that CBDCs utilize advanced encryption and distributed ledger technology, making them resistant to counterfeiting and fraud.

Notably, commercial banks have a keen interest in CBDCs for various reasons. Firstly, they seek to maintain their relevance in the ever-evolving digital financial landscape as CBDCs gain popularity. Secondly, banks recognize the potential of CBDCs to enhance payment efficiency, allowing for streamlined and cost-effective services for their customers. Lastly, leveraging CBDCs could lead to reduced operational costs by minimizing the need for physical cash handling.

Risks Associated with Central Bank Digital Currencies

While CBDCs offer promising benefits, they also come with certain risks and challenges:

  • Cybersecurity. CBDCs must ensure robust cybersecurity measures to protect against hacking and unauthorized access.
  • Privacy concerns. The digital nature of CBDCs raises privacy concerns as transactions could be closely monitored.
  • Banking system stability. The introduction of CBDCs could impact the stability of the banking system as depositors may prefer holding CBDCs over commercial bank deposits.

CBDCs Today

As of July 2023, several countries have taken significant steps toward implementing CBDCs. Below, we will have a look at those that have advanced the most with CBDCs adoption:

  • 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 at the beginning of 2020. The People’s Bank of China has been actively testing and rolling out its Digital Currency Electronic Payment (DCEP) system, aiming to enhance financial inclusion and reduce cash dependence. Its CBDC, known as digital yuan, is already used in some sectors. In April 2023, public sector workers in an eastern Chinese city were set to be paid fully in digital yuan, which was a significant push for the country to popularize the currency.
  • Sweden. The country has long been interested in CBDC and was one of the early testers for digital currency implementation. Riksbank, the central bank of Sweden, started the e-krona project in 2017 to analyze the need for an e-krona. It has been exploring the issuance of the e-krona since then to address the declining use of cash in the country. As of 2023, Sweden is getting ready for further phases of e-krona testing prior to the e-krona pilot focusing on offline payments and sustainability.
  • The Bahamas. In 2020, the Central Bank of The Bahamas launched the Sand Dollar, a digital version of the Bahamian dollar, to promote financial inclusion across its islands. Paying with Sand Dollars is the same as paying with cash in Bahamian dollars.

It is also worth noting that by December 2022, all G7 economies have moved into the development stage of a CBDC, which tells about the widening adoption of central bank digital currencies. The future of CBDCs looks promising, as more countries are considering or piloting their own digital currencies. The adoption of CBDCs is expected to evolve gradually, taking into account technological advancements, regulatory considerations, and public acceptance.

Bottom Line

Central Bank Digital Currencies represent a significant advancement in the global financial system, offering potential benefits in terms of financial inclusion, payment efficiency, and monetary policy implementation.

However, the successful implementation of CBDCs requires careful consideration of the associated risks, cybersecurity measures, and the impact on the existing banking system. As countries continue to explore and develop their CBDC projects, it is crucial to strike a balance between innovation and risk management to ensure a stable and inclusive financial system. Hence, the future of digital currencies remains a topic of great interest and scrutiny in the financial world.

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FAQ

What is a Central Bank Digital Currency?

A CBDC is a digital form of a country’s fiat currency issued and regulated by its central bank. Unlike physical banknotes or coins, CBDCs exist only in electronic form and are backed by the full faith and credit of the issuing country’s government.

How do CBDCs work?

CBDCs use distributed ledger technology (DLT) or blockchain to record and validate transactions. These digital currencies can be issued in two primary forms: retail CBDCs for use by the general public and wholesale CBDCs for financial institutions and banks.

What are the types of CBDCs?

There are two main types of CBDCs: account-based and token-based. Account-based CBDCs are linked to the individual’s account at the central bank, while token-based CBDCs are stored in digital wallets or physical devices, similar to cryptocurrencies.

What issues do CBDCs solve?

CBDCs aim to address various challenges in the financial system, including enhancing payment efficiency, reducing transaction costs, promoting financial inclusion, combating illegal activities, and providing an alternative to private cryptocurrencies.

How are CBDCs different from cryptocurrencies?

CBDCs are issued and regulated by central banks, making them a form of centralized digital currency. In contrast, cryptocurrencies like Bitcoin are decentralized, not backed by any central authority, and operate on a peer-to-peer network.

What are the benefits offered by CBDCs?

CBDCs can offer faster and cheaper cross-border payments, increased financial inclusion by providing access to unbanked populations, improved transparency in transactions, and better monitoring of monetary policies.

Are there any risks associated with CBDCs?

While CBDCs offer various benefits, they also come with potential risks. These include cybersecurity threats, privacy concerns, the risk of disintermediation of commercial banks, and potential negative impacts on financial stability.

What are the examples of CBDCs?

Several central banks worldwide are exploring or piloting CBDCs. For instance, China’s digital yuan (e-CNY) and the Bahamas’ Sand Dollar are notable examples of CBDCs in different stages of development and implementation.

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