Central Bank Digital Currency (CBDC) Definition | Investment Dictionary

A central bank digital currency is similar to cryptocurrency. Both currencies are digital, but a CBDC is issued by a country’s central bank as a form of fiat currency (it has no intrinsic value and cannot be redeemed for a physical commodity, such as gold or silver ).

This type of digital currency is still a new concept that a few countries outside the US have already implemented, and many nations are exploring the possibility. Some countries are considering how a central bank digital currency will affect their economy before releasing a version of a CBDC to the public.

This type of currency is catching on as paper money becomes less popular. While people can still buy goods and services with physical cash, a central bank digital currency offers an additional choice. CBDCs are legal tender, meaning they can be used almost anywhere in the issuing country to purchase goods and services.

Each CBDC belongs to one of two categories: wholesale or retail. A wholesale CBDC is exclusively for financial institutions such as commercial banks, credit unions and central banks. CBDCs can make interbank settlements more efficient.

Banks still use traditional money, but a wholesale CBDC can serve as a substitute or an additional resource alongside traditional money.

A retail CBDC is aimed at consumers and acts as a companion or substitute for cash. Instead of being a liability to a private bank, a CBDC is a liability to the central bank.

Both types of CBDCs can potentially reduce the time and costs associated with cross-border payments.

CBDCs and cryptocurrencies are both digital currencies that use blockchain technology. Some companies accept cryptocurrencies in exchange for goods and services, while El Salvador has even made Bitcoin a legal tender. However, this is where the similarities end, and there are some important differences.

The main difference is that the CBDC is centralized, while cryptocurrencies are decentralized. A central bank controls the supply of CBDCs and can inflate these tokens by creating more of them.

Cryptocurrencies are decentralized, making them less vulnerable to a single actor controlling the supply. There are only 21 million Bitcoins (BTC), and that number will never change. This hard shell makes the world’s largest cryptocurrency resistant to inflation.

While limited-supply cryptocurrencies have an edge over inflation, there are significant risks with decentralization. You can be locked out of your crypto fortune if you lose your private key. With a CBDC, you can contact your bank if you have questions about account access.

The regulation of CBDCs offers more stability, while the realm of cryptocurrencies is more like the Wild West, especially if you venture beyond Bitcoin. Cryptocurrencies achieve their valuations based on how people feel about them rather than fundamentals such as a country’s economy, financial growth or other metrics that investors might use for fiat currencies.

In other words, cryptocurrencies are ripe for speculation, while a CBDC is a digitized fiat currency.

Central banks using CBDCs issue a digital version of the country’s currency. Each digital currency has a unique serial number, which makes it easier to identify. However, this layer of protection does not guarantee that the authorized owner initiates the transaction.

Central banks retain control over the currency and its supply. They can set rules for their digital currencies similar to how cryptocurrencies have built-in rules, such as a limit on the number of Bitcoins.

CBDCs can enable faster cross-border transactions while allowing financial institutions and consumers to reduce their costs for those transactions. CBDCs can reduce the need to print physical cash, which can help prevent money laundering and even save money.

Retailers receiving CBDCs may also have less to worry about counterfeit money. In addition, CBDCs can reduce financial fraud because all transactions are posted on a distributed ledger. Crypto blockchains likewise allow the recording of publicly displayed transactions.

CBDCs offer some advantages, but they also present significant challenges. A massive overhaul of the financial system is as risky as it sounds. It is unclear how a sudden shift will affect the prices of goods and services.

CBDCs also go against a core principle that has led to much fanfare around cryptocurrencies. That is, a central authority still controls the money supply and adjusts interest rates.

Central banks have more control over CBDCs coming in and out of accounts because they are liable for the money instead of private banks. Private banks act as intermediaries and compete with each other. This can result in competitive rates and terms; However, an attempt to monopolize control over money can also have disastrous consequences, such as rampant inflation, a shelf life on saved funds and limited access to money, if deemed necessary by the central bank. So, more regulation is not always a good thing.

The US doesn’t have CBDCs, but it floated the idea. The Bahamas, Eastern Caribbean Islands, Jamaica and Nigeria have each introduced a CBDC. However, Nigeria has hardly seen any use for its centralized digital currency, even though cryptocurrencies are popular in the country.

The Bahamas and Eastern Caribbean Islands have issued CBDCs to financially connect remote island communities and strengthen the payment system against natural disasters and pandemics. But the Bahamas’ Sand Dollar, its version of a CBDC launched in 2020, for example, had a muted reception. An International Monetary Fund report from May 2022 indicated that the CBDC accounted for less than 0.1% of the currency in circulation. The Jamaican CBDC Jam-Dex has experienced similar “success”.

Regardless, more than 100 other countries are now in the exploration stage, according to an IMF report in November 2023. At the forefront are central banks in Brazil, China, the euro area, India and the UK

India’s digital rupee recently crossed 1 million transactions in one day, but that was largely thanks to the help of state-owned and private banks as part of an e-rupee pilot program. Banks have been encouraged to deposit employee funds and benefits as CBDCs instead of the regular fiat currency.

Countries have faced an uphill battle in issuing CBDCs. They have not generated much traction compared to traditional money, and their adoption is limited even in the countries that offer it.

Unknown impact on existing financial systems is behind central banks’ reluctance to adopt CBDCs. However, many countries are exploring CBDCs’ potential and see some value in taking steps towards a digital fiat currency.