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What Is CBDC?

Published by Jonathon Jachura

Reviewed by Bowen Khong, ACCA

Central bank digital currencies (CBDCs) have definitely emerged as a hot and debatable topic in the financial space. 

There are banks, governments, and financial institutions that are performing in-depth research and analysis on the technical and economic feasibility of introducing a new form of digital money. But what’s a CBDC? And will CBDCs steal Bitcoin’s thunder? 

What’s a Central Bank Digital Currency?

A CBDC is a new blockchain-based virtual currency that a central bank will issue. As no CBDC has been launched so far, it is only possible to speculate on their design as well as how they work. 

CDBC is short for central bank digital currency, it is an emerging and unique form of digital currency.

There has been increasing interest in cryptocurrencies, such as Bitcoin and Ethereum, because of their decentralized nature. 

Can CBDC take over their hype? CBDC is similar to cryptocurrencies as it is an electronic or digital form of central bank money that you can use to store value or make digital payments in a seamless manner.  

And central banks and other financial institutions around the globe have started studying CBDC. Also, according to a report, about 80% of the 66 banks surveyed have been closely involved in projects and research that were related to CBDCs.

Similar to many cryptocurrencies, such as Bitcoin, CBDC will supposedly utilize the same distributed ledger technology; however, there will be one significant difference– 

Unlike most cryptocurrencies such as Bitcoin, Litecoin, and Ethereum, a CBDC will be a centralized virtual currency governed and issued by a central bank. 

CBDCs can also be defined as ‘programmable money, which means that digital fiat or payment tokens can have specific design attributes and features built into the token itself. 

How do CBDCs Differ from Physical Cash?

While CBDC is reasonably similar to the paper bills in your wallet, storing and transacting with a physical currency can be very inefficient, time-consuming, and tedious at times. 

On the other hand, a digital representation of that value can be more convenient, simple, and efficient.

Categories of CBDC

Broadly speaking, most policy debates these days contemplate two main types of CBDCs. These are wholesale CBDCs, which would facilitate and promote more efficient and simpler central bank clearing operations between a central bank and its member banks. 

On the other hand, retail CBDCs would be available for use by the general public at large. It will effectively be the equivalent of standard banknotes but in digital or virtual form.

Wholesale CBDC

You can exchange or trade this kind of CBDC easily between private banks and central banks. These exchanges will help streamline payments between these financial institutions, enabling faster and more efficient cross-border transactions. 

They will also reduce counterparty credit risk and liquidity risk. 

And these CBDCs are deemed to be the most appealing and attractive project. This is because of its unique ability and potential to make current wholesale financial systems economical, faster, and much safer at the same time. 

Retail CBDC

On the other hand, a retail CBDC is digital money meant for ordinary people and ordinary consumers who will use the money to conduct transactions for their everyday activities. 

This type of CBDC is based on various distributed ledger technologies, such as those using blockchain technology. They promote traceability, availability 24/7/365, and anonymity, which is convenient. 

It also mitigates third-party involvement, hence eliminating the risk of criminal activities, such as money laundering.

The Effects of CBDC on the Economy

There is no denying that if a significant number of a bank’s clients choose to hold CBDC rather than having a bank account, then the bank will have considerably less capital to give out loans. 

This would, in turn, make various loans more expensive. Meaning a thoughtless or unplanned implementation of CBDC without mitigating actions will likely have an adverse and drastic effect on the economy. 

This is probably one of the most important reasons why many central banks haven’t yet jumped at the opportunity to develop a digital currency that will have legal tender status.

Key Characteristics of CBDCs

So far, CBDCs have just been proposed by various central banks and haven’t yet been implemented for either country- or region-specific use.  And to date, over 20 varying CBDC prototypes and models have been developed in the world. 

Notably, the digital Bahamian Sand Dollar in the Caribbean and Yuan in China appears to be the closest CBDCs to release officially.

Also, central banks have proposed and suggested varying degrees of accessibility for various CBDCs. For instance, some have considered developing a CBDC that will be made available to the public, mainly in the event that cash use continues to decline considerably.

The BIS (Bank of International Settlements) has also argued that introducing CBDCs into this context may help diversify retail payment systems.

This will bolster the systems’ ability to bounce back if technological issues interfere with standard private payment infrastructures. 

Benefits of CBDC – Why are so Many Countries Interested

Many governments and banks around the globe are currently evaluating and assessing the adoption of digital currencies for various purposes and reasons. However, they are still far from large-scale deployment. It is clear that some of the substantial benefits and advantages of a blockchain-based CBDC include increased payment efficiency as well as lower transaction costs. 

Reduced Costs and Increased Payment Efficiency 

Having a CBDC will help increase the efficiency and effectiveness of a country’s overall conventional payment system. 

For example, one can argue that blockchain could seamlessly pave the way for real-time and swift gross settlement rather than the existing international payment system that is based on a net settlement. This will save fees to a significant extent.

Market Discipline and Contestability 

And some central banks see CBDCs as potentially offering fair competition for large firms and banks involved in payments and are a means to cap the rents that they can extract.

Increased Accessibility and Financial Inclusion 

Financial inclusion and accessibility could be other practical applications of a CBDC. For example, in emerging markets, the conventional payment system uses many intermediaries in emerging markets, such as commercial banks. 

This often leaves many people unbanked with little to no accessibility to critical financial services, which is a cause for concern. 

In these financial markets and economies where the lack of access to physical currencies is a considerable problem, a CBDC will help eliminate intermediaries and allow a vast unbanked population to have hassle-free and straightforward access to the financial system.

Increase the Total Size of the Economy

For several countries experimenting with a centralized virtual currency, adopting CBDC may pave the way for increasing the total size of the economy. Here is an example. In many developing markets, a large portion of the country’s GDP (gross domestic product) is used to print physical currency bills. Having a CBDC, however, can solve this problem and strengthen and bolster the overall economic position.

Monetary Policy

Many academic scholars and financial pundits view CBDC as a means to improve the transmission of monetary policy. And they argue that an effective interest-bearing CBDC will help increase and enhance the economy’s response to various changes in the policy rate. 

 And that is not all; they suggest and opine that CBDC could be easily used in order to charge negative interest rates, especially in times of prolonged and dire crisis.

Crack Down on Criminals and Tax Evaders

Many countries experimenting with CBDCs are optimistic that they can progress toward a truly cashless economy wherein avoiding the payment of taxes could be almost impossible. 

This is because when the whole financial system is digitized and integrated with a CBDC, it will help crackdown on a shadow economy that encourages and promotes black market transactions as well as undeclared work.

How Will Businesses and Companies Adapt

It is clear that cryptocurrencies and blockchain are technologies that are continuously and rapidly evolving with applications in many new use cases. And this subject matter is inherently complex and technical and requires sufficient expertise and time to navigate. 

This is why senior management should consider having a suitable strategy in place, outlining the potential impact and consequences of CBDCs on their businesses. 

They should also consider implementing a strategy to respond appropriately to the changing landscape. 

For example, companies’ digital asset and management teams will have to collectively build capabilities and competence to perform business operations and understand and effectively manage and minimize the related risks.

Risks of CBDC

It is no secret that CBDC would be a big disappointment to people who purchase cryptocurrencies, hoping that a private and decentralized type of digital cash, such as Bitcoin, Litecoin, or Ethereum, will one day replace fiat money. 

Also, some argue and worry that CBDCs would mean a much greater expansion of government and that the anonymity and secrecy that especially the most private cryptocurrencies provide will continue to enhance their appeal.

And the emergence of CBDCs could be a crucial destabilizing force on the current financial system. This is because if consumers can easily hold direct accounts with any central bank, commercial banks and financial institutions could get drained of their retail deposits, which is concerning. 

CBDCs and Financial Inclusion

We all know that public accessibility is among the significant constraints linked with developing countries. A World Bank report stated that over one billion citizens do not have their bank accounts. 

This is why governments exclude CBDCs from conventional banking services. And lack of money as well as inadequate or poor knowledge of the significance of financial inclusion, are the key reasons for people not receiving banking services.

This is where CBDCs can play a huge role in promoting and fostering financial inclusivity. For example, in a developing country, CBDCs can allow and even enhance public access to various government-backed payment methods even without the need for bank accounts. All they need is just an internet connection.

Final Thoughts 

Central bank digital currencies are a digital form of fiat money. The introduction of CBDC in the economy may be a game-changer. It is essential to strive for quicker and cheaper digital payments and more transparency regarding your funds.

Proponents and advocates of CBDCs argue that blockchain-based fiat money could help solve inefficiencies and streamline operations in the current central banking infrastructure. 

However, those who are more cautious warn that CBDCs could also be prone to hacking attempts or outages. And enthusiasts of DeFi or decentralized finance argue in favor of a financial system that moves away from a rigid centralized authority.

Jonathon Jachura
Jonathon Jachura
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