What is a central bank digital currency (CBDC)?

What is a central bank digital currency (CBDC)?

Central bank digital currencies (CBDCs) are a form of digital currency issued by a country’s central bank. They are similar to cryptocurrencies, except that their 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. With so many countries exploring ways to transition to digital currencies, it is important to understand what they are and what they mean for society.

Understanding Central Bank Digital Currencies (CBDCs)

Fiat money is a government-issued currency that has no backing of a physical commodity such as gold or silver. It is considered a form of legal tender that can be used to exchange goods and services. Traditionally, fiat money came as banknotes and coins, but technology has allowed governments and financial institutions to supplement physical fiat money with a credit-based model that digitally records balances and transactions.

Physical currency is still widely exchanged and accepted; however, some developed countries have experienced a decline in their use, and that trend has accelerated during the pandemic.

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

Objectives of CBDCs

In the US and many other countries, many individuals lack access to financial services. In the US alone, 5% of adults in 2020 did not have a bank account. Another 13% of American adults who had bank accounts instead used expensive alternative services such as money orders, payday loans and check cashing services.

The main purpose of CBDCs is to provide businesses and consumers with privacy, portability, convenience, accessibility and financial security. CBDCs can also reduce the cost of maintenance that a complex financial system requires, reduce cross-border transaction costs, and provide lower-cost options to those who currently use alternative money transfer methods.

CBDCs will also reduce the risks associated with the use of digital currencies, or cryptocurrencies, in their current form. Cryptocurrencies are highly volatile, with their value constantly fluctuating. This volatility can cause severe financial stress in many households and affect the overall stability of an economy. Backed by a government and controlled by a central bank, CBDCs would give households, consumers and businesses a secure way to exchange digital currency.

Types of CBDCs

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

Wholesale CBDCs

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

Retail CBDCs

Retail CBDCs are government-backed digital currencies used by consumers and businesses. Retail CBDCs eliminate intermediary risks – the risk that private digital currency issuers could go bankrupt and lose customers’ 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 or public keys or both. This method of validation allows users to perform transactions anonymously. Account-based retail CBDCs require digital identification to access an account.

Issues address and create CBDCs

The Federal Reserve has identified critical requirements that a CBDC must meet, as well as issues that must be addressed before one can be designed and implemented.

Issues addressed by CBDCs explained

Eliminate the third-party risk of events such as bank failures or bank runs. Any residual risk remaining in the system rests with the central bank. Can lower high cross-border transaction costs by reducing the complex distribution systems and increasing jurisdictional cooperation between governments. Can support and protect the dominance of the US dollar; the US dollar is still the most widely used currency in the world.
Removes the cost of implementing a financial structure within a country to bring financial access to the unmanned population. Can establish a direct link between consumers and central banks, thereby eliminating the need for expensive infrastructure.

Issues created by CBDCs explained

If the US financial structure changes drastically, it is unknown how it will affect household spending, investments, bank reserves, interest rates, the financial services sector or the economy. The effect that a switch to CBDC will have on a financial system’s stability is also unknown. For example, there may not be enough central bank liquidity to facilitate withdrawals during a financial crisis. Central banks implement monetary policy to affect inflation, interest rates, borrowing and spending, which in turn affects employment rates. Central banks must ensure that they have the tools needed to positively influence the economy. Privacy is one of the main drivers behind cryptocurrency. CBDCs will require an appropriate amount of intrusion by authorities to monitor for financial crimes; monitoring is also important because it supports efforts to combat money laundering and the financing of terrorism. Cryptocurrencies have been the target of hackers and thieves. A digital currency issued by the central bank is likely to attract the same crowd of thieves. Therefore, efforts to prevent system penetration and theft of assets and information will need to be strong.

CBDCs vs. Cryptocurrencies

The cryptocurrency ecosystems provide a glimpse of an alternative currency system in which cumbersome regulations do not dictate the terms of every transaction. They are difficult to duplicate or forge and are secured by consensus mechanisms that prevent tampering.

Moreover, cryptocurrencies are unregulated and decentralized. Its value is determined by investor sentiment, usage and user interest. They are volatile assets more suitable for speculation, making them unlikely candidates for use in a financial system that requires stability. CBDCs reflect the value of fiat currency and are designed for stability and safety.

Central Bank digital currencies at a glance

Central banks in many countries have pilot programs and research projects to determine the viability and usefulness of a CBDC in their economy. As of March 2023, there were 11 countries and territories with CBDCs. They are the Bahamas, Antigua and Barbuda, St. Kitts and Nevis, Monserrat, Dominica, Saint Lucia, St. Vincent and the Grenadines, Grenada and Nigeria. Eighteen countries now have a pilot program, including seven of the G20 economies, and 32 countries have a program in development. According to the Federal Reserve, the US is one of those countries investigating whether a CBDC “could improve upon an already secure and efficient US domestic payments system.”

The Bottom Line

Many countries are developing central bank digital currencies (CBDCs), and 11 have already implemented them. A CBDC’s main purpose is to provide businesses and consumers with privacy, portability, convenience, accessibility and financial security. Many individuals around the world have no access to bank accounts, so a CBDC will give them a way to get paid, hold their money and pay bills. CBDCs can also reduce the maintenance a complex financial system requires, reduce cross-border transaction costs, and give people using alternative money transfer methods lower-cost options.