What Is Central Bank Digital Currency (CBDC)?

Since the advent of cryptocurrencies, the notion of a CBDC has been circulating. In this post, we summarise everything you need to know about them.

Because of the COVID-19 pandemic and digital payments becoming mainstream, the world is shifting towards a more digital lifestyle.

A Central Bank Digital Currency (CBDC) might be used to help create a more inclusive global financial system by facilitating cross-border transfers.

CBDCs have been suggested since 1989, when DigiCash was released, and 1996, when e-gold was released. CBDCs may not have become as popular without Bitcoin, which encouraged governments to reconsider CBDCs.

What Is Central Bank Digital Currency (CBDC)?

A CBDC is a digital version of a country’s fiat money. These currencies are issued by central banks or governments.

Although CBDCs are comparable to digital currencies like cryptocurrencies, there are important distinctions and characteristics.

Governments are hoping to use blockchain technology to create a more efficient and accessible national monetary system by issuing CBDCs.

Through a CBDC, transactions could be processed quicker than with a traditional currency, as everything would be digitally verified and tracked in real time.

Advantages of CBDCs

In theory, CBDCs can provide many positive benefits to a country. CBDCs can offer financial inclusion, technological innovation, more efficient transactions, and economic growth, among other benefits. Here are a few examples:

Disintermediation — In theory, CBDCs would lower the reliance on banks, allowing for quicker and real-time payments and money transfers. This process is known as disintermediation.

Quicker Transactions — Individuals and businesses often desire payments to be processed rapidly. When there is a slow payment process, the merchant must assume the risk of the payment not being verified or completed. In theory, CBDC transactions are verified almost immediately, thus eliminating this risk.

Low or No Transaction Fees — Using current payment systems requires paying a transaction fee. American Express, Mastercard, and Visa are all examples of services for which a fee is charged. Since there have been no CBDCs that have been released thus far that require a transaction fee, there may not be one in the future either.

Financial Inclusion — Having a CBDC account at a central bank might facilitate financial inclusion, as it might allow any resident or citizen of the country to access the country’s financial system without having to create a traditional bank account.

Keeping a Check on Illegal Activity — With every unit issued by a central bank being digital, a CBDC can track transactions from minting onwards, creating a digital trail for every transaction. This might make it easier to detect criminal activity and prevent crimes like money laundering.

More Efficient Tax Collection — Everything being tracked with a CBDC may make tax evasion and avoidance more difficult, making it impossible to conceal funds in an offshore bank account or in other ways.

Transaction Record — With a CBDC, a central authority records and verifies the exchange of value. An audit trail of the exchange, which includes the relevant data, can help prevent mistakes like giving someone the incorrect amount of change. Furthermore, the victim of a crime or the sender of an errant money transfer can have their funds returned (quicker than with a fiat transaction) with a CBDC in instances in which the transaction is reversed.

Disadvantages of CBDCs

CBDCs being centrally controlled is a major drawback because it means that there is one point of failure that can bring the entire system to a halt.

With the current CBDC models, everything is tracked, as the central authority records all transactions. Some see this as a problem, as the government or central bank would always know how much money users have and what they spend it on.

What is the function of CBDCs?

CBDCs, or central bank digital currencies, are a form of cryptocurrency issued by central banks. They are part of a broader initiative by central banks to explore the possibilities of issuing their own digital currencies. There are a few possible ways CBDCs could be used.

One is as a substitute for cash, in cases where cash is no longer available.

Another is as a digital version of fiat currencies, such as dollars or euros, which would be used for everyday purchases.

Yet another option would be for CBDCs to function like regular cryptocurrencies, like bitcoin, with the benefit of being backed by a central bank.

Whatever the use case, CBDCs have the potential to improve the efficiency of transactions, as compared to traditional cryptocurrencies like bitcoin.

A CBDC can be implemented only if a central bank or government maintains a database collecting information about all the everyday transactions. In other words, the central authority would know how much CBDC every individual, company, or entity had at any time.

Types of CBDCs

These CBDCs are used by banks to store reserve deposits with a central bank.

Wholesale-only CBDCs

A wholesale-only CBDC can increase payment efficiency and serve as a means to bolster central bank reserves. Banks can efficiently move money between themselves and a central bank using this method.

General-purpose CBDCs

General-purpose CBDCs are distributed by central banks to the general public.

This type of CBDC is one of the more popular ones, as it can help achieve the goal of financial inclusion for the general public and promote a cashless society by eliminating fiat money.

Which countries are experimenting with CBDCs?

Currently, many countries are examining the creation of CBDCs, but only a few have actually started the process. Here are some countries that are examining the establishment of CBDCs:

China

The Chinese digital currency (e-CNY) is currently in the pilot phase, and China is working hard to ensure that everything is in order before officially releasing it. The most recent development sees citizens of multiple local cities being able to pay for trains, buses, and subways with e-CNY.

India

In India, CBDC pilot testing continues. The Reserve Bank of India is preparing to test the CBDC with some public sector banks, and the CBDC has not yet been fully implemented. India is therefore far along in its CBDC pilot testing, despite its CBDC not having been fully implemented yet.

The Bahamas

The Bahamian Sand Dollar is a CBDC launched in the Bahamas. This CBDC is currently available for retail and wholesale application and aims to provide more financial inclusion to those living in the Bahamas. It is one of the most developed CBDCs around the world in terms of being readily available to the public.

CBDCs vs Cryptocurrencies

While CBDCs are based on the same technology that cryptocurrencies are based on, they are not identical.

Decentralisation is one of the most well-known characteristics of cryptocurrencies like Bitcoin. Cryptocurrencies, like Bitcoin, are decentralised, meaning no one institution controls them. Although a CBDC is controlled by a central bank or government, it verifies and stores transactions to a certain extent.

There are several cryptocurrencies that are publicly accessible and permissionless, while CBDCs are more than likely run on private blockchains under government or central bank control.

With cryptocurrencies, users are not necessarily required to reveal their identity, and to a certain extent, they can decide how much information they disclose. A CBDC, on the other hand, would most likely require a large amount of personal identity information and keep records, such as for tax purposes.

A CBDC is not pegged to a fiat currency, as it is the fiat currency itself in digital form. However, some cryptocurrencies are pegged to fiat currencies, such as USDC to the United States Dollar.

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Final Words

Governments have begun looking into CBDCs as a way to stay ahead of the curve as the world continues to become more digital. While CBDCs are not the same as cryptocurrencies, they should be distinguished from them.

CBDCs, which may come with several advantages such as financial inclusion, are a good example. There may be trade-offs in terms of privacy and centralisation, but CBDCs are not the same as cryptocurrencies.

Learn more about the difference between crypto tokens and coins after familiarising yourself with CBDCs.

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